Economic growth and nominal interest rates have remained relatively low and stable across Europe in the past 15 years. Except for a short period during the Eurozone debt crisis (2011-2013), most of the European economies grew on a stable path and inflation was under control, closely aligned with central banks’ long-term goals. However, two big events affected the continent in the last two years that changed this economic background: the global pandemic and the war in Ukraine. After a strong freeze-out of the economic activity in 2020, many businesses were able to re-open in 2021, but the GDP rebound brought some supply issues in many markets and products that pushed the core inflation. Simultaneously, the Russian invasion of Ukraine put additional pressure on oil, gas and other commodities, driving the total inflation to levels not seen in almost 20 years. Now, global monetary policy is set to change; therefore, higher nominal interest rates and higher inflation represent a challenge for several asset classes, including listed real estate. Let’s see how.
Future inflation does not necessarily imply an increased risk for property investors. In the event of higher inflation, property owners would be entitled to increase rents (indexation/rent reviews). Higher rents would eventually lift values, considering the usual six- to 18-month time lag and also an increase in corporate profits for tenants, although increasing interest rates will also increase financial costs.
In our latest inflation report, we discussed this issue, commenting that “property companies see changes in both revenues and expenses when inflation rises. In the case of European listed real estate companies, there is evidence of a strong and positive correlation between corporate profits and inflation as well as shareholders’ returns and inflation” (EPRA, 2022)1 . In the short term, rising inflation may lead to higher volatility because nominal interest rates will also rise, but many listed property companies across the continent have made significant efforts during the last decade to improve their debt profile.
When interest rates are rising, investors may decide to invest in other asset classes – such as investment-grade bonds – because their rate of return is becoming more ‘attractive’. Moreover, the financing costs of real estate companies may also grow if debt is contracted at floating rates. However, today the vast number of European property companies have less leverage, with an average loan-to-value (LTV) below 37%, where debt is largely fixed-rate while the average maturity of this debt is quite long. And approximately 85% of total outstanding debt is contracted at a fixed interest rate, 1.8% on average.
As a consequence, debt issued by listed property companies is now less sensitive to changes in nominal interest rates than in previous cycles of interest rate hikes. Between April 2021 and April 2022, government bond yields for Germany, Sweden and the UK increased 112 bps on average, while the corporate bonds of property companies increased 157 bps, representing an increase in the risk premium of 45 bps (in function of maturity). This seems to be very reasonable and, in our view, reflects how investors continue trusting the listed real estate industry and the conservative debt management of many property companies.
Listed real estate can differentiate itself from other asset classes, even in the current market conditions. Rental flows are (partially) indexed, which could drive up valuations and corporate profits. Conservative financing policies could be considered a strength by many investors, and several property markets still show healthy fundamentals and some signals of undersupply, supporting the expectation of rental growth in the near future and the idea of a resilient industry that is well prepared to face the increasing inflation and higher interest rates environment.