Author: Bloomberg

Source: elEconomista.com

The war in Ukraine has altered investors’ perceptions of certain assets, which have shifted from being among the most sought-after to barely sparking interest. The invasion triggered a surge in energy and food prices, prompting central banks to embark on one of the most aggressive monetary tightening cycles of the century, thereby undermining the foundation of the European real estate boom of the past decade.

Markets have long been sounding the alarm about real estate. The Stoxx 600 Real Estate Index has dropped by 40% this year, and valuations have fallen to levels reminiscent of the financial crisis. While part of the real estate activity occurs between private parties, the true impact of the ‘end of cheap money’ is now becoming evident in the sector.

Land Securities, the developer of the building that will house Deutsche Bank’s headquarters in London, recently completed the sale of this asset but had to accept an offer 15% lower than those available before the war. This transaction is just one example of the damage facing the European real estate market. Sellers who dare or need to enter the market will have to navigate this challenging environment, as many are currently avoiding it.

Another example is the sale of Bank of America’s headquarters in London, which has been halted. It’s not the only one, as around €6 billion in office real estate offers have been withdrawn from the market, according to data from broker CBRE Group, compiled by Bloomberg.

“The current situation is like a dance floor, with buyers on one side and sellers on the other, but neither willing to start dancing,” explains Ian Rickwood, founder of private equity firm Henley Investment Management, to the agency.

However, this paralysis may soon end as many companies will need to refinance at a time when financing costs have soared. For some, the debt markets are effectively closed, and there will be loans maturing that cannot be repaid. The refinancing gap for loans in the UK, France, and Germany is expected to reach €24 billion over the next three years, according to Hans Vrensen, head of research and strategy at AEW Capital Management.

“This will inevitably lead to forced sales in both commercial and residential properties,” warns Nicole Lux, senior researcher at Bayes Business School. Wealthier investors will benefit from this situation as they encounter bargains.

Divestments to Cancel Debt

The real estate group Vonovia plans to sell over €13 billion in assets to cancel debt and mitigate rising financing costs. Other companies, like Adler Group and SBB, which secured cheap credit, are beginning to consider divestments before their loans mature and they have to seek more expensive financing.

The role of the debt markets is crucial in real estate. The world’s largest asset typically follows the yields on government debt, offering a higher margin than sovereign bonds to compensate for its greater risk and attract investors.

During years of negative interest rates, buyers accepted minimal returns. However, now the cost of money is rising, as reflected, for example, by the German 10-year bond. The yield on the bund started the year in negative territory and has surpassed 2.3%. This pressure is filtering through to large property owners.

For instance, the sale of Deutsche Bank’s London offices shows that office yields have risen from 4% to 4.7%, according to Bloomberg Intelligence analyst Sue Munden. Meanwhile, the yield on UBS’s London headquarters was 3.6% last December, more than one percentage point lower. The pressure will be more pronounced in continental Europe than in London, as yields have fallen more in the eurozone than in the UK over the past five years due to Brexit.

Impacts on Valuations and Balances

This situation is worrying for real estate companies, as they will feel the changes and fluctuations in their balance sheet valuations. For example, the value of a building with rental income of $10 million drops by $100 million if the yield moves from 2% to 2.5%.

However, some property owners, like Vonovia, still insist that their financial statements will remain stable in the third quarter just ended. According to analysis firm Green Street, this optimism means that appraisers “are still lagging behind” the expected interest rate curve.

One solution for property owners would be to increase rental prices to compensate for declining valuations. However, this path seems now unfeasible as cost pressures on tenants are very high, a situation that has been ongoing since late last year when inflation was not even close to current levels.

Increasing Pressure

Real estate services firm Savills estimates that more than 40% of projected office constructions in London for 2026 will be postponed, in some cases for over a year. Nevertheless, some fundamentals of real estate still show strength, with demand remaining strong, supply limited, and debt levels modest compared to pre-global financial crisis levels.

“Historically, real estate recessions have been triggered by two situations: excessive debt or excessive cranes,” says James Seppala, head of real estate for Europe at Blackstone. “We are not seeing either of these situations right now,” he says. However, this more optimistic outlook is not reflected in real estate portfolios, which have lost 39% of their value, according to Bloomberg Intelligence. If markets are correct in what they are currently reflecting, such a magnitude of decline could lead to foreclosures on the scale of the 2008 crisis.

“I would trust what the markets are discounting to guide me on where we are heading, rather than focusing on rental and occupancy data,” advises Peter Papadakos, head of research for Europe at Green Street.

Real estate companies need different sources of financing at a time when the bond market is inaccessible. However, it is logical that banks now reduce this type of exposure. “I suspect that the last thing banks want is to take all of that back onto their balance sheets,” says Mike Sales, CEO of Nuveen Real Assets. “There is still not much leverage, but that could easily change if yields shift,” he explains.

But if banks continue to provide financing, it won’t be cheap. Rising interest rates and higher borrowing costs in the sector have led borrowers to pay double what they did nine months ago, according to an AEW report. And recent volatility in the UK—due to the announcement of tax cuts—will push up costs even further.

All of this means that, although property companies are holding out for now, the pressure will continue to increase. Many will have to resort to selling under worse conditions or less profitable terms to raise liquidity.

“The current challenge is that multiple challenges are converging simultaneously,” says Henning Koch, CEO of Commerz Real AG, and that “makes it very difficult to steer a company in the right direction.”