Investment: does the ecb strangle the real estate boom??

The European Central Bank raises interest rates. What are the concrete implications for the real estate industry?? IMMOBILIEN AKTUELL analyzes the current situation with regard to new construction, willingness to invest, transaction activity and financing of projects.

As a result of the interest rate hikes by the European Central Bank (ECB), the trend of rising interest rates on the money and capital markets that has been underway since the beginning of the year reached its interim peak at the beginning of the fourth quarter of 2022. After the ECB had already raised interest rates by 75 basis points (bp) in September, the central bank decided to increase them again by 75 bp at its last meeting in October. As a result, long-term interest rates rose sharply again in September. While the ten-year interest rate swap was still at 1.50 percent in August, the swap rose to 3.21 percent in the course of the following month. Since the central bank has announced further interest rate hikes, the cycle of interest rate hikes is likely to continue. Is the ECB stifling the real estate boom with this move – or will the industry be able to live with the increased interest rate level?

ECB with interest rate hikes only at the beginning?

The central bankers justify their interest rate steps with the fact that the inflation rate with the consumer prices is clearly too high and for longer time over the target value will remain. All in all, therefore, they continue to focus on supporting demand – and thus reducing the risk of "inflation expectations shifting permanently upward" – as part of the monetary policy stance. One of the reasons is the historically high inflation rate in October of 10.7 percent in the euro zone. In July, the rate had still been 8.9 percent. Once again, the rate was significantly higher than expected by the majority of economists surveyed in advance.

The fact is that rapidly rising interest rates are increasingly challenging the real estate industry: In the housing market, groups of buyers are breaking away, institutional investors are waiting, prices are falling for the first time in a long time, and at the same time pressure is growing in the residential rental market. The poor mood in the industry can be seen from individual indicators such as the real estate climate index: Following the sharp drop of 9.4 percent in September, Deutsche Hypo's index fell even more sharply in October, by 13.1 percent to just 64.8 points. There were stronger declines in the office climate (down 16.4 percent to 59.6 points) and the retail property climate (down 28 percent to 37.1 points).

Consequences for the real estate market: new construction business collapses

The ECB warned of corrections in the real estate market back in May when it presented its Financial Stability Report, pointing out that already overheated prices in housing markets could fall if mortgage rates rose abruptly. According to the report, houses in the eurozone are overvalued by an average of almost 15 percent and in some countries by as much as 60 percent. The ECB reiterated its call for banks to hold more capital in line with their exposure to the real estate sector.

New construction is particularly affected by the changes. Increased interest rates, high construction costs, expired KfW subsidies make new construction unprofitable in many locations. The number of building permits already fell by 17 percent in Germany in the first half of 2022. A further decline in construction activity is to be expected; many projects have already been discontinued. In parallel, new business in the construction industry fell by 6.0 percent in August compared with the previous month, and there was even a drop of 15.6 percent year-on-year when adjusted for inflation, the Federal Statistical Office (Destatis) reported.

Development of future projects stalled

Massive impact of the "new normal" in the financial markets on project development. Due to the higher interest costs, the need for fixed interest rates is also increasing accordingly among property developers, says Helge Scheunemann, Researcher at JLL. In addition, the cost of borrowing is prohibitive compared to yields, and as a result, debt financing is almost non-existent. Only those who have sufficient equity capital still undertake projects; if at all, then only with a very low debt ratio, emphasizes Helge Scheunemann. Since the target group lacks money, potential buyers have less purchasing power – which is directly noticeable on the real estate market. Overall, there was also a limited transaction activity. As the time to complete a transaction has doubled, processes are being discontinued, says Helge Scheunemann. As a result, the rise in financing costs has had a greater impact on investment markets than on rental markets.

The relationship between real estate prices and central bank interest rates

Rising interest rates are often associated with lower real estate prices. The logic behind this inverse relationship is as follows: Retail banks adjust their mortgage rates to the central bank's key interest rates. If the central bank's key interest rate rises, real estate financing becomes more expensive, which leads to lower demand and ultimately to a decline in prices.

The measures taken by the FED are a direct response to the strong economic growth in the U.S. and are intended to prevent the economy from overheating. Even the European economy, with its slower but still existing growth, is not immune to a rate hike by the ECB.

Looking at the periods when the FED raised interest rates due to a good economy, for example from December 1995 to April 1997, when the ten-year yield increased by 118 basis points, the impact on real estate values and the overall return on real estate investments in the U.S. was not negative. On the contrary, prices and yields rose by ten percent over the same period. The same trend can be observed in Europe, with real estate prices increasing from 1999 to 2002 despite rising interest rates.

Even if interest rates rise to above four percent in the first quarter of 2023, the ten-year interest rate swap is likely to come back in the course of the year, making real estate investments more attractive.

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