Higher Interest Rates Return

Inflation

And Higher Interest Rates Have Caused Great Discomfort In Global Capital Markets

The global capital markets have experienced a turbulent time of late, especially in the United Kingdom following Liz Truss’ market shaking “mini-budget” in late September 2022.

Russia’s invasion of Ukraine and global supply chain issues caused a rapid increase in inflation, sparking fear across the globe. In the UK, levels hit as high as 10.1% in July and have only marginally subdued with winter months still ahead. This level of inflation has led to central banks increasing short term interest rates in an e ort to regain price stability going forward.

James Webb Senior Vice President Eastdil Secured

The Bank of England base rate has risen from 0.25% to 3.00% since February 2022 and 5 year SONIA swap rates have risen from 1.1% at the start of the year to 3.9% at the time of writing, peaking at 5.3%. The UK and European real estate markets had not seen interest rates of these levels in years and weaning o cheap debt is no mean feat.

Inflation and higher rates have hit both ends of the commercial real estate risk spectrum. On the core end, the days of investors buying a 4.00% yield and achieving a levered IRR of 6.00% - 7.00% disappeared seemingly overnight. On the opportunistic end, cost inflation and higher interest rates have eroded development returns and created uncertainty around exit cap rate assumptions. Those with fixed price construction contracts and swapped or hedged debt could feel rather pleased with themselves.

The assets that are most likely to outperform in this environment are the best in class ESG assets - projects that go above and beyond both environmentally and socially. It is not only investors that have this high on their agenda but tenants too. The combination of strong tenant demand and lack of available stock is expected drive rents in this part of the occupational market.

From a capital markets perspective, positive news is that unlike during the Global Financial Crisis, the real estate market is still awash with capital. In fact, real estate closed end funds’ dry powder in 2022 amassed to a substantial $377 billion, according to Preqin.

Since the arrival of Rishi Sunak, the gilt markets have calmed down and hopes will be that Cirque du Tory is over and certainty will reach the white cli s of Dover. But despite the relative calm, the UK SONIA forward curve projection still has a prediction of 3.1% in 5 years’ time, significantly above 2021 levels. However, forward curve projections have seen significant volatility in 2022 and forward curve projections have historically been less accurate after the immediate 12-18 months following the projection date.

Once inflation has stabilised at an acceptable level, central banks will have the ability to lower interest rates, which may become a positive catalyst for the market. For now, it is for investors to find transactions that work at their pricing and to be brave and counter-cyclical when the appropriate opportunity arises.