Since a peak in August 2021, the FTSE EPRA/NAREIT Developed Europe Index – which tracks the performance of listed real estate companies in Europe – has sold off sharply, declining over 40% by the end of March 2023. The last time these levels were seen on the index was around 2012 – over ten years ago.
The sell-off has been caused by rising interest rates, which have two separate effects on real estate:
- Real estate is usually financed with debt. This means that interest payments rise as interest rates rise, reducing profits.
- Real estate valuations are affected by interest rates. As rates rise, real estate values fall. Like bonds, there is an inverse relationship between real estate yields and real estate prices.
For some sectors, there are further concerns – residential real estate may not be able to raise rents as it is politically unpopular or even forbidden, and commercial real estate (particularly offices) are undergoing structural changes in the post-pandemic, work-from-home world. Further, recession fears abound. So, some real estate sectors are seeing rising costs but not rising revenues.
Vonovia, Europe’s largest landlord, owning or managing 622,000 rental units across Germany, Sweden, and Austria, is an instructive example of how interest rates affect real estate. Since 2013, Vonovia has generated €28.2 billion of rental income – but, almost as importantly, it also earned €24.6 billion from the revaluation of its rental properties. German bond yields were, up to 2022, close to zero or negative. As a result, real estate investors were happy to pay lower yields (higher prices) for real estate, which was a powerful tailwind for Vonovia’s real estate portfolio. Vonovia’s own rental yield fell from 5.9% to a low of 2.6% in 2021.
The sell-off in real estate companies, then, is just a reversal of the past decade’s gains, as the market now believes higher yields are here to stay. As ever, the stock market is a discounting machine and is pricing in further write-downs as higher interest rates put more pressure on valuations.