The impact of market volatility on real estate

The impact of market volatility on real estate

The news from Ukraine is disturbing and relentless. Lurking under the headlines are dramatic economic gyrations — higher interest rates, higher inflation, successive waves of “risk-off” and “risk-on” market sentiment, yield curve changes, and rising commodity prices. This volatility should not go unnoticed; it is the focus of our April Macro Deck.

In March, interest rates generally moved higher after an initial “safe haven” effect as sovereign yields fell following the invasion of Ukraine (see pages 3, 6). Stock markets also fell, then rebounded and ended the month up as the month progressed (see pages 7-8). Elevated inflation indicators continued to be reported from around the world (see pages 11-16), and the concern that higher inflation will remain persistent became widespread. The US Federal Reserve became the 11th G20 Central Bank to raise interest rates since the COVID pandemic (see page 4-5). The US Fed has taken the approach of communicating direction well ahead of action, and the signal is the March rate hike will be the first of several in the coming months (see page 17, 24).

Higher interest rates are a concern to real estate investors because real estate is very dependent on borrowing. In 2020, economic distress was accompanied by falling interest rates, and the net result was higher real estate values. The question now is if higher interest rates will lead to lower real estate values. There is no global answer to this question. The outlook for each market, sector, and property is impacted by secular trends, economic growth, ability to raise rents, and buyers’ access to leverage. Consideration of all these factors, alongside interest rates, determines the value outlook. In some cases, accelerating NOI growth will outweigh any negative impact from higher rates; while in other cases, the balance will go the other way.

Inflation’s impact on real estate is similarly nuanced. It has been decades since developed economies have seen a higher inflation regime. Yet, the case for including real estate in a diversified portfolio has included its inflation hedging ability. The increase in real estate allocations over the last two decades may have been more about risk-adjusted returns than inflation hedging. Now that we actually have elevated levels of inflation, will real estate’s hedging power hold up?

One challenge of demonstrating if real estate is an inflation hedge is that real estate data from the last period of elevated inflation in the late 1970s and early 1980s is limited (see page 18). The year 2021 had elevated inflation — how much of an inflation hedge was real estate last year? The answer–based on 2021–seems to be “it depends”. The first critical element for real estate to be an inflation hedge is an ability to raise rents. This depends on landlord-favorable market conditions, which was the case in some investment segments, but not others.

In 2021, there were great-to-amazing returns for residential and industrial properties in many markets, while office and retail returns were often mediocre at best (see page 45). This corresponds with the sectors where landlords had pricing power and where they didn’t. The conclusion to date is that while lease terms and expense burdens are useful to guide the ability of a property to hedge inflation (see page 46), the most important element is the market power to raise rents.