With the turnaround in interest rates, the times seem to be coming to an end in which there was only one direction for real estate prices: upwards. For investors, real estate nevertheless remains an attractive investment – especially if it is actively managed. Lukas Hanimann of Zurich Invest is convinced of that.
Swiss economy proves robust in 2022 despite global problems. Unemployment rate of 2% and inflation at 2.5% are at a low level. In 2023, the SNB expects inflation of 0 to 2%. The stable, in part slightly deflationary environment since 2010 is thus abandoned. The SNB therefore raised interest rates again for the first time to -0.25%. Further increases are under consideration.
These factors and the uncertainties on the financial market have recently led to a rapid and volatile increase in 10-year federal bonds. In August, interest rates on 10-year federal bonds were 0.70%. In June they were still at 1.45%, in January at 0%. Increases are also being seen in the interest rates of fixed-rate mortgages. Only SARON remained in negative territory at -0.20%. The offer prices of real estate, on the other hand, remained stable, in some cases even increased slightly. Thus, the spread, i.e. the risk premium, of real estate investments compared with risk-free government bonds decreased.
Real estate offers inflation protection
Real estate investors are now faced with the question of how to deal with rising interest rates and the inflationary environment. "Due to historically low discount rates, speculation on appreciation should be discontinued. To secure and increase rental income in the long term, on the other hand, the focus should increasingly be on active asset management," explains Lukas Hanimann, Product Manager Real Estate at Zurich Invest.
Variable rental income often made it possible to pass on inflation. In the case of commercially used space, leases are usually 100% linked to the national consumer price index. According to the expert, they are mostly protected against inflation. Incidental costs, especially energy costs, could mostly be passed on to the tenant. The rising rental income due to indexation supports the capital value even with slightly rising discount rates.
In the residential sector, however, the picture is different. "Permanent leases are linked to the mortgage reference rate, which correlates only to a limited extent with inflation. In addition, the adjustment will take place with a time lag," says Hanimann. According to Credit Suisse forecasts, the reference interest rate should not increase before 2024. An increase of 0.25% of the reference rate generally leads to rent increases of 3%. Credit Suisse sees the reference interest rate rising to up to 3% by 2027. This would correspond to rental growth of 21% in existing rents. Whether such increases are at all financially viable for tenants depends to a large extent on the development of wages.
Office properties are becoming more attractive again
"Due to the direct allocation of inflation to rent demands and noticeably improved fundamentals, office properties are becoming more attractive again," says Hanimann. "The oversupply of space in Swiss metropolitan areas in recent years has decreased significantly."Thanks to declining construction activity and greater absorption of space due to increased demand, vacancy rates have fallen significantly. In Zurich and Geneva, vacancy rates approach 10-year lows in 2022. At the same time, the expert observes a marked increase in asking rents, especially in A-locations. Hybrid working models would have further increased the importance of location, accessibility and quality of properties.
Compared to the residential segment, commercial properties have seen lower appreciation in recent years. Income yields are therefore on average between 50 and 75 basis points higher. "This can be an interesting factor for investors, especially with rising interest and discount rates. The office market is also far less regulated. Political risks, such as the tenant protection bill adopted in Basel, are thus eliminated," Hanimann explains.
Fundamental data underpin the attractiveness of the residential market
However, the residential market also remains attractive thanks to positive fundamentals. Switzerland is a tenant country, so demand for rental apartments remains high. Due to the positive demographic development – according to the Swiss Federal Statistical Office, the 10 million mark will be reached by 2040 – the demand for living space will increase in the long term. The supply shortage is also being exacerbated by sluggish construction activity and increasing regulation of the market.
Supply rents are therefore showing a slight upward curve. Compared to the previous quarter, current asking rents increased by 0.6%, according to WuestPartner. Year-on-year, the increase amounts to 1.5 percent. A trend reversal is expected for existing rents, which fell as a result of the continuous reduction in the reference interest rate. Further nominal rent increases are therefore to be expected, according to the expert.
Rising construction prices protect capital value
The construction industry again recorded an increase in construction costs, due in particular to increases in production costs, raw materials and energy prices, as well as the shortage of skilled labor. The supply chain problems caused by the pandemic have also not yet been fully resolved.
According to the Swiss Federal Statistical Office, the construction cost index for buildings rose by 10.4% year-on-year. "The resulting slowdown in construction activity will lead to a short- to medium-term shortage of available space. The disproportionate increase in the cost price of new buildings will support the capital values of existing properties in particular," says Hanimann.
According to Credit Suisse, building applications for conversion, extension and renovation work worth approx. 14 billion. Swiss franc – a high since the first survey in 1995. At the same time, the volume of new building applications decreased. Conversion work is particularly about energy renovations, due to rising energy costs and the demand for renewable energy sources.
Reduce risk through active sustainability and asset management
The entry into force of the EU Taxonomy Regulation in 2022 increases the likelihood that the requirements for the sustainability of real estate will also increase further in Switzerland. In combination with rising tenant expectations regarding sustainability, low-consumption properties should become the industry standard in the medium term. Properties that do not meet these requirements run the risk of being rated increasingly negatively.
"In order to reduce the risks of increased vacancies, unexpected costs and 'stranded assets,' a professional asset management plan that combines ecological and economic aspects in the best possible way is of central importance for every property. This includes, for example, the pricing of CO2 emissions during the purchase or the development of targeted strategies to align older properties with the Paris climate agreement," explains the expert.
In addition, market trends could be quickly identified and appropriate measures taken with an active asset management strategy. This would help to increase rental income in the long term and secure assets.