Continuing pressure on returns from direct real estate investments
Direct Swiss real estate investments have once again proved to be crisis resistant. The ongoing economic recovery is further strengthening their earnings base. The latest increases in long-term interest rates are therefore unlikely to scare off real estate investors due to the lack of alternatives.
Economic recovery enables investors to find new opportunities
The strong economic recovery that began last year is likely to continue. Furthermore, as the year progresses, widespread lifting of the remaining pandemic restrictions is expected. Accordingly, investors are once again focusing on longer-term prospects.
How should real estate portfolios now be adjusted for the period after COVID-19? First, the earnings outlooks of the individual segments have shifted. Second, the budding inflationary trends in the US and the euro zone remind us that the era of ultra-low interest rates will one day end.
Direct real estate investments are in unabated demand
Switzerland, however, is not quite there yet. Even though capital market returns did trend upwards at the start of the year, given an average net cash flow return of 3.3% for residential and mixed-use investment properties, the return premium for real estate investors remains high in the long-term comparison. Extensive capital-market-driven transactions by real estate funds and listed real estate companies in the past year demonstrate strong demand – as does the strong growth of outstanding mortgage lending to companies. Said lending was sometimes up by 6% compared to the previous year.
The transaction data for residential and mixed-use investment properties supports this impression. For instance, price growth in these segments accelerated once again over the past year, according to the SWX IAZI Investment Real Estate Performance Index. In the fourth quarter of 2021, transaction prices were up by 5.9% year on year and the total returns even reached 9.1%. This can in particular be traced to the price growth for multi-family dwellings.
Low interest rates positively influence the valuations of direct real estate investments
Even though capital market returns have transcended their lows, the interest rate support for the valuations of investment properties will likely continue for the time being. Since 2004, the average discount rates applied for the valuation of the properties of Swiss real estate funds have dropped from 5% to 3.3%. In this context, the difference between the discount rate and the risk-free interest rate temporarily increased to almost 400 basis points. Due to the long-term interest rate increases, this difference dropped down to almost 320 basis points in 2021. Accordingly, there is still room for downward adjustments of the discount rates.
Real estate investors expect improved earnings prospects
Even though the economic recovery will likely continue in 2022, the COVID-19 pandemic has left its mark on the real estate market. First, it led to demand shifts within and between the various segments. Second, it gave rise to inflationary trends via expansionary monetary and fiscal policy, as well as via disruptions in the global supply chains. Even though these effects remain manageable in Switzerland, investors should still expect continued moderate increases in long-term interest rates and rethink their strategies.
After all, unlike previously, the classic buy-hold strategy is unlikely to guarantee returns in the longer term. Especially in top locations, the return compression has reached an extent that signals a strong potential for value corrections in case of future interest rate increases. This calls into question the risk/return ratio of conservative strategies, such as a concentration on core residential properties in urban centers. This makes it all the more important to have an investment strategy that relies on good regional and sector diversification and takes into account properties with potential to increase earnings or real estate developments, as well as investments abroad.
Attractive real estate investments for 2022
A summary assessment of the individual real estate segments and examples of preferred properties.
Thanks to heavy demand from tenants and a decrease in construction activity, the earnings prospects have generally improved – especially outside urban centers. Especially in suburban and rural areas, properties in easily accessible municipalities are therefore suitable as investment properties.
The marketing situation will remain difficult due to the uncertainty caused by remote working. The amount of available space and vacancy rates are therefore expected to remain at a high level. There are opportunities to be found, for example, in properties situated in central locations with a large number of points of interest.
The shift in turnover to the online channel has accelerated during the pandemic. Moreover, the structural change in Switzerland is not yet very advanced. Retail spaces are under the threat of corrections, from both the income and the price side. The best opportunities come from investment properties in top locations such as shopping streets in major urban centers.
Logistics real estate benefits from the growth in online retail. In Switzerland, the offering is limited due to land scarcity; this means that further revaluations can be expected in the longer term. This all speaks in favor of investing in this segment – for instance, in small city logistics spaces.
Hotel and hospitality industry
Hospitality and hotels geared towards vacationers will likely recover after the end of the pandemic. Interesting investment properties can be found in innovative urban hotels geared towards tourism with a young, urban clientele.
Source: Credit Suisse