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Rising rates raise prospect of property crash

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Brenda McKinley has been selling homes in Ontario for over 20 years and has been shocking to veterans for the past two years.

The price of her patch in southern Toronto rose by as much as 50 percent during the pandemic. “The house was sold before we got the lawn sign,” she said. “It was not uncommon to have 15 to 30 offers … There was a feeding frenzy.”

But in the last six weeks, the market has turned around. McKinley estimates that the value of a home has dropped by 10% within the time it may take for some buyers to complete their purchase.

This phenomenon is not unique to Ontario and the housing market. Real estate investors, homeowners and commercial landowners around the world are all asking the same question as central banks raise interest rates to curb runaway inflation.

Chris Brett, Head of Capital Markets for Real Estate Company CBRE in Europe, the Middle East and Africa, said: “Changes in debt costs are having a huge impact on all markets. I don’t think there is any immunity … Speed ​​surprised us all.”

Listed real estate stocks, which are closely monitored by investors looking for clues as to what will ultimately happen to illiquid real assets, have been put into the tank this year. The Dow Jones US Real Estate Index has fallen almost 25% year-to-date. UK real estate stocks have fallen about 20% over the same period, even faster than the benchmark index.

According to MSCI data, the number of commercial buyers aggressively looking for assets in the US, Asia and Europe plummeted from a pandemic peak in the fourth quarter of last year at 3,395 to just 1,602 in the second quarter of 2022. did.

According to MSCI, pending transactions in Europe are also declining, with contracts at the end of March at € 12 billion, compared with € 17 billion in the previous year.

Transactions already on the train have been renegotiated. “Anyone who sells everything [price] Missing or otherwise by future buyers [buyers] Ronald Dickerman, president of Madison International Realty, a private equity firm investing in real estate, said: “Anyone underwrites [a building] Needs to be reassessed. .. .. The amount of price revisions currently taking place in real estate cannot be overemphasized. ”

The reason is simple. An investor who was willing to pay $ 100 million for a block of apartments a few months ago would have been able to borrow a $ 60 million mortgage at a borrowing cost of about 3 percent. Today, they may have to pay more than 5%.

Rising rates mean that investors need to accept lower overall returns or push sellers to lower prices.

Justin Curlow, Global Head of Research and Strategy at AxaIM, one of the world’s largest asset managers, said:

The question for real estate investors and owners is how broad and deep the fix will be.

During the pandemic, institutional investors defended by betting on sectors supported by stable long-term demand. In the midst of fierce competition, prices for warehouses, rental condominiums, and offices for the life sciences business have skyrocketed.

“All the big investors are singing from the same hymn sheet. They all want housing, urban logistics, high quality offices. Defense assets,” he said. Tom Lee Hee, head of physical asset research at MSCI in Europe, the Middle East and Asia, said. “It’s a real estate issue, you get the spirit of the flock.”

With cash rushing into the tight corners of the real estate market, there is a risk that assets will be priced incorrectly and there is little room for them to erode even if interest rates rise.

For owners of “defensive” real estate that are bought at the top of the market and need to refinance, rising interest rates create the prospect that owners will “pay more loans than they expect to make in real estate.” , Said Lee Oberby, head of commercials. A survey of mortgage-backed securities at Barclays.

Before the Federal Reserve began raising interest rates this year, Oberby estimated that “zero percent of the market” was affected by so-called negative leverage. “I don’t know the current amount, but anecdotally it’s pretty popular.”

Manus Clancy, senior managing director of New York-based CMBS data provider Trep, said, while less likely to be a crater in values ​​in the more defensive sector, “pay a lot for this. I’ve done it, “he said.

“They thought they could raise their annual rent by 10% in 10 years and costs would level off, but consumers are hit by inflation and can’t pass on costs,” he said. He added.

It looks volatile if the investment is considered to have been made reliably just a few months ago. Higher risk bets now look toxic.

Increased e-commerce during pandemics and the shift to hybrid work have exposed office and shop owners. Rising interest rates can now overthrow them.

A paper published this month, The Apocalypse of Working from Home and Office Real Estate, argued that the total value of offices in New York would eventually drop by almost one-third. This is a cataclysm for owners, including pension funds and government agencies that rely on taxes. income.

“In our view, the value of overall office stocks is 30% less than in 2019, which is a $ 500 billion hit,” said Columbia University professor or real estate and finance author of the report. One, Stijn Van Nieuwerburgh, said.

“Because a very large segment of the unlisted office market (80-85 percent) is very uncertain and there is little trade,” he added, the decline has not yet been registered.

But when the old office changes hands, he expects the discounts to be tough, as the funds will end their life or the owners will have a hard time refinancing. If the value drops enough, he predicts enough mortgage defaults to pose systemic risk.

“If the loan-to-value ratio exceeds 70% and the value drops by 30%, the mortgage is underwater,” he said. “Many offices have over 30% mortgages.”

According to Curlow, as many as 15% of companies have already defeated the value of US offices in the final bid. “There are higher levels of vacancies in the US office market,” he added, adding that “interest rates are zero and everything started with the Fed.”

UK office owners also need to navigate changing labor patterns and rates of increase.

Landlords with modern, energy-efficient blocks are doing relatively well so far. However, the rent of the old building has been hit. More than 25 million square feet of UK office space exceeds requirements this week after real estate consultant Lambert Smith Hampton found in a survey that 72% of respondents are trying to reduce office space as soon as possible. Suggested that there is a possibility.

The hope that retail, the sector most disadvantaged to pandemic investors, may enjoy a recovery has also been shattered.

Leading UK investors, including Landsec, have bet on shopping centers over the past six months, hoping to catch rebounding deals when people return to physical stores. But inflation did not get the recovery on track.

“Many shopping center owners wanted a certain level of rent,” said Mike Prue, an analyst at Jeffreys. “But due to the cost of living crisis, the rugs were pulled from under them.”

As interest rates rise from very low levels, there is also an increased risk of a reversal in the rising housing market, from Canada and the United States to Germany and New Zealand. Oxford Economics currently expects prices to fall next year in the fastest-growing market in 2021.

Many investors, analysts, agents and real estate owners have told the Financial Times that the risk of a decline in real estate valuations has increased sharply in recent weeks.

However, few people expect a serious crash like 2008. This is partly due to a slowing appetite for lending practices and risks since then.

“In general, commercial real estate feels like it’s on the verge of a downturn, but Covid has grown so strongly that there’s room to lie down before it affects anything. [in the wider economy]”Overbee said. “Before 2008, the leverage was 80% and many ratings were fake. We aren’t there in the long run.”

“There’s definitely stress in the small pockets of the market, but it’s not systematic,” said the head of a major real estate fund. “I’m like 2007. Promised an acquisition of € 2 billion to € 3 billion using the bridge format. “

He added that more than 20 companies looked volatile before the financial crisis, but this time there were probably five.

Private equity investor Dickerman believes that the economy is in long-term distress reminiscent of the 1970s and that real estate will turn into a long-term decline. However, betting wins and losses still exist because “there has never been time to invest in real estate when the asset class is so differentiated”.

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