Research article


How will tighter monetary conditions impact global real estate investment? Yolande Barnes looks at the implications of rising interest rates.

London tends to attract opportunistic, short-term buyers

▲ London tends to attract opportunistic, short-term buyers

The world of real estate investment seems to have fallen into two halves since the global financial crisis (GFC) of 2007–08. In one, investors are accessing debt and making leveraged purchases and in the other, investors are using equity, seeking income and/or security. This means that there are significant differences in both the timescale of investments and the hurdle rates.

This division between the equity-rich and the equity-poor has a geographical component. North American real estate deals tend to be more highly leveraged than Asia Pac deals, as we found in our analysis of a sample of big-ticket ($10 million plus) deals in 2015. Figure 1 shows the loan to value ratios found and how they differ between geographies.

Figure 1

FIGURE 1Loan to value ratios

Leveraged investments are more likely to be short to medium term than equity investments because debt eventually has to be repaid. Timescales will be set by lenders rather than the nature of the project or built environment requirements.

Sophisticated lenders will understand the timeliness of real estate investments: the influence of market cycles, development planning and build phases, income optimisation as well as maturity and depreciation profiles. Others will be more influenced by the availability and cost of wholesale funds, imposing these on the real estate investment environment rather than vice versa.

Leveraged investors will clearly be more constrained by monetary conditions than equity investors. Interest rates will impact on equity investors as well, inasmuch as their opportunity cost of funds will be affected. However, temporary disparities between these and the income or total returns on their property holdings will be more easily carried than by highly leveraged investors who need to service interest.

As an example, the effects of leverage on performance can be seen in China on developers. Figure 2 (below) shows the impact of gearing on relative outperformance and underperformance. This is despite the fact that borrowing rates have reduced substantially over the past year in China.

Figure 2

FIGURE 2China developers: profit growth and leverage in 2015

Sources: City Research

In the post-GFC world of low interest rates and constrained lending, equity has been searching for a home and asset price inflation has been inevitable. Low and even negative bond yields in some countries have meant that the opportunity cost of funds are low. As a result, investment in high-yielding jurisdictions has been particularly attractive. In prime locations of major cities, which are favoured by overseas investors, yield compression has been rapid and pronounced, sometimes taking yields to record lows as competition for trophy assets in safe havens has led to higher prices and lower cap rates.

The highly leveraged investor has found it increasingly difficult to compete unless there is a clear value-add component to their purchase. Leveraged US funds buying into London, for example, have tended to be opportunistic and shorter term while some Asian and Middle Eastern investors have looked for longer-term holds for income growth and/or longer-term capital growth.

In a world where borrowing costs and opportunity costs are returning to ‘more normal’ conditions, both equity investors and leveraged funds are likely to refocus on yield levels and the potential for income growth. However, there is still a level of ‘global real estate arbitrage’ to be completed between equity investors targeting lower hurdle rates and high-yielding jurisdictions. The variety of net effective income returns across world cities illustrates this.

Higher-risk emerging markets may be expected to remain higher yielding but economic recovery and growth in transparent, developed markets may yet see further yield compression, especially where rental growth is expected. We expect global cross-border capital flows in real estate to continue to reflect a pattern of relatively cheap money at source and higher yields at destination coupled with a global search for rental growth. As such, many of our value-add and opportunistic researcher tips for 2016 and beyond are focused on secondary (and lower grade) property, second-tier locations (which have seen lower levels of investment in the past seven years). We also focus, especially, on new and alternative asset classes where the weight of investor money has not yet had such a dramatic impact as on the mainstream asset classes.

Other articles within this publication

6 other article(s) in this publication