Join The Multi Asset Lab for less than £2 pcm per asset class and receive:

  • Monthly updates on 15+ separate asset classes from best-in-class commentators
  • Free Subscription to the Property Chronicle Magazine - Digital Edition (normal price £50pa)
  • 30 days free trial!

Real estate asset values, like other financial assets, are affected by changes in interest rates. Given the pace and magnitude that interest rates have shot up in the past couple of years, it’s unsurprising that listed real estate (often REITs) in most markets has taken a hammering. On the contrary, magical clouds of smoke and financially engineered mirrors have kept private market values elevated.

Figure 1 (from NAREIT research) shows how REIT implied yields moved sharply higher from late-2021 for a year, and since then have stabilised at a higher base. Amazingly, private market valuation yields moved lower initially, but with the steep rise in interest rates, eventually followed suit – albeit they have ~75bps and 185bps catching up versus transaction and implied yields their listed peers.

Different property sectors have been affected by varying degrees. There are several reasons for the divergence in performance, but they are principally due to a combination of the below factors:

  • Debt cost and availability. Fortunately, leverage is lower than past cycles by 10-20 percentage points, and as a result the impact should be muted versus past cycles.
  • The structural headwinds / tailwinds of a property sector are exacerbated by narratives – i.e., retail was untouchable in the last cycle and office in the current one; while optimism around industrial, self-storage, towers was high, it has somewhat faded in the past year.
  • Starting yields – where low yields (which often equates to high growth expectations) should be disproportionately impacted by rising cost of capital and discount rate mechanism.
  • Tenant credit risk. Concern is low / localised, but this may change quickly in a recession.
  • Supply and demand dynamics – Some concerns of last cycle speculative supply as demand declines; equally some markets continue to be structurally undersupplied.
  • The polarisation of markets – secondary real estate often has higher volatility in downturns.
  • Other Factors: regulatory, environmental, technological, demographic, behavioural, etc…

Figure 2 shows a breakout of implied yields by property sectors for REITs, and NCREIF (Open Ended Diversified Core Equity or ODCE Funds) appraised and transactional yields.

Given reduced appetite for commercial real estate, transactional volumes are sharply lower and as a result non-listed funds cannot sell enough to keep pace with redemptions. The lucky investors that manage to redeem early are likely to benefit from appraised values that are artificially too high (i.e., 100-200bp lower cap rates) at the expense of those locked in, who face further declines based on transactional and implied REIT cap rates.

The above list should serve as a reminder that analysing markets is challenging given the multitude of considerations and a multi-year horizon required for direct real estate investments. Direct real estate investment involves a c.10% round trip in transaction costs, it requires specialist operating skills / platform, deep pockets, and market contacts to ensure access to best deals. Investing in funds is a viable alternative for most institutions and costs materially less, but liquidity remains a key issue.

By contrast, the round trip in listed real estate is anywhere from 0.2% to 1.0% depending on the market and/or REIT. The expertise required is analytical not operational / platform based, and a wide network is good for informational purposes but not necessary for transactions. Just a few dollars can match the best-quality portfolio, management, and diversification relative to what can be achieved through private markets with a billion of dollar mandate.

However, there is the volatility elephant in the [listed real estate] room that needs addressing. It is nothing short of a roller-coaster; thrills from outsized returns in up markets are great, but capital loss spills in times of distress are hard to stomach – especially so when it’s self-inflicted, as was the case in prior cycles when leverage was too high. Barring a few repeat offenders, listed real estate appears far better placed with more moderate levels of debt (~25%-35% is now more common vs. the 35%-45% pre-GFC), maturities staggered further out, and rates fixed or capped. 

The dominating factor responsible for the broad-based sell off in REITs across markets has been concerns about rising debt expenses, and to a lesser extent the availability of debt. Figure 3 shows the debt refinancing and likely cost progression (by weighted average cost of debt) for the Top-10 UK REITs (roughly two-thirds of the total UK market cap). Despite the sharp 30-40% drop in REIT values, the staggered and relatively long debt maturity profile means the impact of rate rises will be felt over multiple years – by which time, rental growth should limit the damage.

With the single biggest hit to real estate values coming from rising rates, investors will be watching this closely. Figure 4 shows our various scenarios for inflation and economic activity for the UK market (US markets are likely to perform marginally better in terms of inflation and growth) together with estimated base rates and probabilities. The wide range – and even one open-ended scenario where anything could happen given the rule book is constantly being rewritten – reflects the heightened uncertainty. 

Our two main scenarios, stagflation and a mild recession speak to weak / negative growth, but it’s the inflation number that will drive rates and ultimately asset values. The Goldilocks scenario, which has a 10% probability, would do little for private values as they’ve not been fully marked down but likely to be materially positive for REITs where large discounts are expected to unwind. Hot Inflation and Deflation are both low probability tail risk events and equally bad for private real estate.

So, in summary, when we typically worry about excess volatility in the listed market, it is nearly always downside volatility. We have largely had this with plunging REIT valuations. Looking ahead, we expect less downside and greater upside (not the volatility long investors typically worry about) in almost all our scenarios – therefore the volatility elephant in the REIT room is more mouse-like at this point.

Join The Multi Asset Lab

Only £1 per month per asset class | 30 Days Free Trial!