Direct real estate investments – the market is heading for a soft landing
Direct real estate investments have been in high demand in recent years. With the interest rate reversal in 2022, investment properties are no longer the obvious choice. That said, the positive performance on the consumer market and Switzerland's economic stability have prevented direct real estate investments from losing too much of their appeal.
Investment properties no longer the obvious choice
Rising inflation and the interest rate reversal instigated by the Swiss National Bank in June 2022 signaled an end to the era of negative interest rates – which had seen real estate investments increase considerably in value in recent years. The yield premium compared to ten-year government bonds averaged 363 basis points between 2015 and August 2022.
By the end of 2022, the yield premium had fallen to 144 basis points. Real estate is therefore no longer the obvious choice for many investors, but the decline in the yield premium is likely to be exaggerating the loss of appeal – real estate investments continue to offer many benefits.
Real estate investments protect against inflation
Unlike bonds, real estate investments offer a certain degree of protection against high inflation rates. This is due to the fact that rental income is linked to the consumer price index – to a limited degree for residential properties and a much larger degree for commercial properties. Depending on inflation expectations and the possibility of passing on costs to tenants, the real decline in the yield differential is lower than the figures suggest.
The transaction market remains comparatively robust
The Swiss real estate transaction market remained robust in H1 2022, and this was reflected in further price growth. The price increase slowed in H2.
There are two reasons why there has so far not been a correction. Firstly, there was significant excess demand in the past, which must now be reduced. Secondly, the Swiss economy is extremely robust and rent rises are likely due to the scarcity of property, especially in the residential sector.
However, market sentiment has clouded during the past year, and this is reflected in price expectations. Price indices, which usually capture market status with something of a delay, are likely to continue declining in 2023.
Investment property valuations under pressure
Discount rates have long been declining year on year, creating scope for portfolio revaluations; last year was generally no exception. Portfolio valuations therefore defied the interest rate reversal. The decline in discount rates did slow, however, and the first increases were even noted among real estate funds. Rising interest rate expectations and falling prices on the transaction market are likely to see rising discount rates become the new reality in 2023, putting pressure on the valuations of investment properties.
Good yield prospects partially cushion higher interest rates
Properties can better resist the interest-driven downward pressure if rental income increases at the same time. The prospects are particularly good for residential property here, given that the shortage of rental housing characterizing the market is evident from the rising asking rents. In addition, a rise in the reference interest rate, which we expect for the first time in September 2023, will allow some of the rising borrowing costs and inflation to be passed on to tenants after a delay.
This market development will also be evident in the portfolios of institutional investors. In residential real estate, the loss of rental income due to vacancy rates has halved within just three years. The decrease was particularly apparent outside of downtown areas. As a result, investors can expect real increases in rental income there too.
Shift in demand to real estate investments in rural areas
The slight shift in demand away from downtown areas and toward more rural regions was partly caused by the pandemic. This trend is likely to continue, however. The reasons for this include:
- Consolidation in downtown areas is too slow
- Price differentials between downtown areas and surrounding areas
- Increased remote working
In the medium term, therefore, a falling risk premium is to be expected outside of the centers for easily accessible locations and in metropolitan municipalities as well as in some rural regions. Price corrections are likely to be smaller here than in prime locations in the major urban centers.
Interest rate reversal calls for adjustment of investment strategy
The widespread and successful strategy of focusing on core properties in downtown areas in recent years is likely to lose its appeal due to low cash flow returns and rising discount rates. By contrast, active portfolio management and balanced regional and sectoral diversification are becoming more important.