Real estate investments: Changing return opportunities with real estate portfolios

What is the impact of the interest rate reversal on the real estate portfolio?

The interest rate reversal is changing the real estate market in Switzerland. The impact of the increase in value on the overall return on real estate investments is likely to decline. How institutional investors can respond to these developments and prepare their real estate portfolios for the future.

"Real estate is with us throughout our entire lives and is very visible," says Stefan Meili, Head of Pension Funds & Corporate Investors for Region Zurich, Credit Suisse (Switzerland) Ltd., at Credit Suisse Real Estate Market Perspectives 2023. However, it is not only the visible parts that play an important role in the valuation of real estate, he continues, but also the invisible ones, especially interest rates.

Higher financing costs due to interest rate reversal

"Interest rates and scarcity are currently the two dominant elements in the Swiss real estate market," confirms Fredy Hasenmaile, Head of Real Estate Economics at Credit Suisse (Switzerland) Ltd. The interest rate reversal has resulted in a doubling or even tripling of the mortgage interest costs. At the same time, the development of discount rates is facing a turning point in 2023: for the first time in a long time, they are expected to rise again over the entire year. "This puts a certain amount of pressure on the valuations," says Fredy Hasenmaile. Accordingly, real estate investments are no longer as attractive as in previous years.

Unlike other countries, however, the real estate market in Switzerland is resilient. Even Swiss real estate is not entirely spared from price corrections though, says Fredy Hasenmaile: "But the market is heading for a soft landing." The price corrections in Switzerland are likely to remain within a manageable range compared to the rest of the world. This is also due to the solid economic environment in this country. Among other things, Switzerland benefits from relatively low inflation and correspondingly lower interest rate hikes.

Scarcity in the Swiss real estate market creates opportunities

At the same time, immigration supports the demand for housing and exacerbates scarcity, the second defining issue on the Swiss real estate market. The main reason for the shortage is clear: "There is simply not enough being built," says Fredy Hasenmaile. A housing shortage will be difficult to avoid.

For real estate owners, this development also offers opportunities. Starting in June 2023, reference rates are expected to rise and in combination with declining vacancies will result in higher rents. "We are rapidly moving from a tenants’ market to a landlords’ market," explains Fredy Hasenmaile. The earnings prospects are correspondingly positive. However, in terms of overall returns, higher rents are unlikely to fully compensate for the decline in value increases.

Rental prices in Switzerland are rising again

Rental prices in Switzerland are rising again

Annual growth rates of rental price indices and development of the reference interest rate

Source: Wüest Partner, Federal Housing Office, Credit Suisse
Last data point: Q4/2022

Historical performance and financial market scenarios are not reliable indicators of future results.

Cash flow returns will be central to real estate investments in the future

For listed real estate funds, 2022 was an exceptional year. The index lost 15.2%. Christian Braun, Head of Business Development Swiss Products at Credit Suisse Asset Management (Switzerland) Ltd., gives a more detailed breakdown of performance: "Payout yields remained solid, and changes in net asset values were still very positive in 2022. However, the fund's premiums fell on average from 42% to 13.6%."

The rising discount rates are creating risks for investment foundations in the real estate sector. The good returns in recent years have largely been based on appreciation in net asset values. "Therefore, it’s now crucial to hold investment foundations that offer an attractive cash flow return," explains Christian Braun. In future, he says, the wheat will be separated from the chaff.

Focus on sustainability in commercial properties

What does this mean for the management of real estate portfolios? Currently, a very selective approach is advisable when purchasing properties, says Silvio Preisig, Head of Real Estate Asset Management at Credit Suisse Asset Management (Switzerland) Ltd. "Cash flow management will be extremely important to compensate for the trend toward falling returns on appreciation." For residential real estate, the starting position for this is extremely positive, thanks to rental growth and low vacancy rates. But the office market has also developed well over the past 18 months.

In addition, there is a strong demand for energy-efficient buildings in commercial real estate. "Many large tenants are looking for green lease agreements to fulfill their own sustainability strategies," explains Silvio Preisig. The topic of flexible working and correspondingly flexible rental models will also determine the market in the coming years. Overall, Silvio Preisig drew a positive conclusion despite the current risks: "The glass is still half full. We still see many opportunities in real estate investments."