Real estate in a rising rate environment

Pension funds have turned to real estate in search of income and diversification in the lower-for-longer environment. As interest rates and bond yields rise, how do the dynamics at play impact real estate?

Not all markets are equal

In Europe and Japan, inflation is primarily driven by temporary factors such as fuel and energy costs. As such, interest rates are expected to remain relatively low (or negative).

In the US and the UK, inflation appears more persistent owing to flexible labour markets, which gave rise to ‘The Great Resignation’ during the pandemic. This resulted in a labour and skills shortage as economies reopened, in turn pushing up wages. 

Rapid recovery has driven inflationary pressures globally, exacerbated by the war in Ukraine. The big question is what this will do to economies, and how well central banks are able to manage economic risks through monetary policy to keep a recession at bay.

“Prime property yields still have the potential to offer a positive spread over government bonds.”

The impact on real estate

Businesses’ ability to expand is integral for real estate performance, through tenant demand for space. Weaker economic growth and rising living costs could therefore squeeze companies’ profits, and curb rental growth potential.

The current environment may place upwards pressure on property yields, partly through the denominator effect of rising risk aversion in bond and equities markets. Rising debt costs are also likely to prompt repricing, as investors adjust.

Notwithstanding rate increases, more uncertainty means deals are being reassessed, and secondary real estate are becoming cheaper. This primarily affects poorer quality assets, especially in weaker locations, with shorter lease lengths, voids, and greater capital expenditure requirements to bring them up to date.  

Does real estate still reflect attractive relative value?

In the context of rising bond yields, this is a key question – especially given uncertainty around rental growth prospects. Yet prime property yields still have the potential to offer a positive spread over government bonds owing to an inherent illiquidity premium and the volume of capital chasing real assets. Real estate also offers the benefit of a low correlation to other asset classes, in addition to protection against inflation. 

This isn’t the first time investors have faced elevated bond yields; in the 70s and 80s bond yields exceeded property yields. During the eurozone crisis, Spanish property yields ran parallel.

Unleveraged investors may therefore be able to tolerate a smaller yield gap between property and bonds in the medium term, assuming landlords can pass on higher inflation, in part, through higher rents. What’s more, we believe there is unlikely to be a dramatic shift in the short term since real estate revaluations lag bond yield movement.

While real estate may see less relative value for a period, we believe the property risk premium is likely to return to its historic average, over time. Yields look particularly resilient in markets with higher rental growth potential. 

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.