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Rising rates raise prospect of property crash

Brenda McKinley has been selling homes in Ontario for over two decades and even for a veteran, the past few years have been shocking.

Prices in her area south of Toronto rose by as much as 50 percent during the pandemic. “Houses sold almost before we could get the sign on the lawn,” she said. “It was not unusual to get 15 to 30 offers. † † there was a nutritional frenzy.”

But in the past six weeks, the market has turned around. McKinley estimates that homes have lost 10 percent of their value in the time it takes some buyers to complete their purchase.

The phenomenon is not unique to Ontario, nor to the residential market. As central banks raise interest rates to curb runaway inflation, real estate investors, homeowners and commercial landlords around the world are all asking the same question: Could there be a crash?

“There is a clear slowdown everywhere,” said Chris Brett, head of capital markets for Europe, the Middle East and Africa at real estate firm CBRE. “The change in the cost of debt is having a major impact on all markets, everywhere. I don’t think anything is immune. † † the speed surprised us all.”

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Listed real estate stocks, closely monitored by investors looking for clues as to what could eventually happen to less liquid real assets, have fallen this year. The Dow Jones US Real Estate Index is down nearly 25 percent so far. UK property stocks have fallen about 20 percent over the same period, falling further and faster than their benchmark index.

The number of commercial buyers actively seeking assets in the US, Asia and Europe has fallen sharply from a pandemic peak of 3,395 in the fourth quarter of last year to just 1,602 in the second quarter of 2022, according to MSCI data.

Ongoing deals in Europe have also declined, with a €12 billion contract at the end of March from €17 billion a year earlier, according to MSCI.

Deals already in the works are being renegotiated. “Anyone who sells everything becomes” [price] chipped by potential buyers, or else [buyers] walk away,” said Ronald Dickerman, president of Madison International Realty, a private equity firm that invests in real estate. “Anyone who is insured” [a building] must revalue. † † I cannot emphasize enough the amount of re-pricing that is happening in real estate right now.”

The reason is simple. An investor willing to pay $100 million for an apartment complex two or three months ago could have taken out a $60 million mortgage with a borrowing cost of about 3 percent. Today, they may have to pay more than 5 percent, negating any benefit.

The rise in rates means investors must either accept a lower total return or push the seller to lower the price.

“It’s not showing up in agent data yet, but anecdotally it’s coming through a correction,” said Justin Curlow, global head of research and strategy at Axa IM, one of the world’s largest asset managers.

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The question for real estate investors and owners is how widespread and deep each correction can be.

During the pandemic, institutional investors defended themselves by betting on sectors supported by stable long-term demand. The price of warehouses, blocks of rental apartments and offices equipped for life sciences companies rose duly amid fierce competition.

“All the big investors sing from the same hymn sheet: they all want housing, urban logistics and high-quality offices; defensive assets,” said Tom Leahy, MSCI’s head of real asset research in Europe, the Middle East and Asia. “That’s the problem with real estate. You get a herd mentality.”

With cash sloshing into tight corners of the real estate market, there is a danger that assets will be mispriced, leaving little margin to erode as rates rise.

For owners of “defensive” properties bought at the top of the market who now need to refinance, rate hikes create the prospect of owners “paying more on the loan than they expect to earn on the property,” said Lea Overby, principal of the commercial department. investigation of mortgage-backed securities at Barclays.

Before the Federal Reserve started raising interest rates this year, Overby estimated that “zero percent of the market” was affected by so-called negative leverage. “We don’t know how much it is now, but anecdotally it’s fairly widespread.”

Manus Clancy, a senior managing director at New York-based CMBS data provider Trepp, said that while values ​​in the more defensive sectors were unlikely to collapse, “there will be plenty of men saying ‘wow, we’ve got too much here. paid for’.”

“They thought they could raise rents 10 percent a year for 10 years and costs would stay the same, but consumers are plagued by inflation and they can’t pass the costs on,” he added.

If investments that were considered certain a few months ago look precarious; riskier bets now look toxic.

An increase in e-commerce and the shift to hybrid work during the pandemic exposed office and retail owners. Rising rates now threaten to topple them.

A paper published this month, “Work from home and the office real estate apocalypse,” stated that the total value of New York’s offices would eventually fall by nearly a third — a disaster for owners, including pension funds and the government agencies that depend on their taxes. income.

“Our view is that the entire office stock is worth 30 percent less than it was in 2019. That’s a hit of $500 billion,” said Stijn Van Nieuwerburgh, a professor of real estate and finance at Columbia University and one of the authors of the report.

The decline has not yet been registered “because there is a very large segment of the office market – 80-85 percent – that is unlisted, very opaque and where there has been very little trading,” he added.

But if older offices change hands, money comes to the end of their lives, or owners struggle to refinance, he expects the discounts to be significant. If values ​​fall far enough, he foresees enough mortgage defaults to pose a systemic risk.

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“If your loan-to-value ratio is above 70 percent and your value falls by 30 percent, your mortgage is under water,” he said. “Many offices have more than 30 percent mortgages.”

According to Curlow, final offers already deduct 15 percent of the value of US offices. “In the US office market, you have higher vacancy rates,” he said, adding that America is “ground zero for rates — it all started with the Fed.”

UK office owners are also dealing with changing work patterns and rising rates.

Landlords with modern, energy-efficient building blocks have done relatively well so far. But the rents of older buildings have been hit. Real estate consultancy Lambert Smith Hampton this week suggested that more than 25 million square feet of office space in the UK could be obsolete, after a survey found that 72 percent of respondents wanted to cut back on office space as soon as possible.

Hopes have also been dashed that retail, the sector most out of favor with investors facing the pandemic, could see a recovery.

Major British investors, including Landsec, have been betting on shopping centers for the past six months, hoping to catch up on trade as people return to brick-and-mortar stores. But inflation has knocked the recovery off course.

“There was this hope that many mall owners had that there was a rent level,” said Mike Prew, an analyst at Jefferies. “But the cost of living crisis has pulled the rug from under them.”

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As interest rates rise from ultra-low levels, so does the risk of a reversal in the residential markets where they have risen, from Canada and the US to Germany and New Zealand. Oxford Economics now expects prices to fall next year in those markets where they rose fastest in 2021.

Numerous investors, analysts, agents and property owners told the Financial Times that the risk of a decline in property valuations had risen sharply in recent weeks.

But few expect a crash as severe as 2008’s, in part because lending practices and risk appetite have declined since then.

“Overall, it feels like commercial real estate is heading into a recession. But we had strong growth in Covid so there’s some room to go sideways before it affects anything [in the wider economy]Overby said. “Before 2008, the leverage was 80 percent and many appraisals were fake. We’re not there yet.”

According to the head of a large real estate fund, “There is certainly stress in smaller parts of the market, but it is not systemic. I don’t see many people saying. † † “I have committed to a €2 billion to €3 billion acquisition using a bridging formula,” as in 2007.”

He added that while more than 20 companies looked precarious in the run-up to the financial crisis, this time there were maybe five.

Dickerman, the private equity investor, believes the economy is poised for a long period of pain reminiscent of the 1970s, which will plunge real estate into a secular decline. But there will still be winning and losing bets because “there has never been a time to invest in real estate when asset classes are so differentiated”.

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