The sharp rise in interest rates across most major economies in the past 18 months has had a knock-on effect on the pricing of commercial real estate. This trend, however, appears to be coming to an end.
The question now for property investors isn’t how high interest rates may go in the short term, but where rates will settle in the longer term.
Where next for interest rates?
Interest rates are ultimately determined by the supply and demand of capital via investment and savings behaviour. Principally, weaker economic growth has underpinned a steady decline in rates over the past four decades.
Central bank average policy rates
Source: Savills Research using Macrobond
The recent rise in interest rates – driven by a post-pandemic surge in inflation – is likely to be temporary. Central banks will eventually bring rates down to a level they consider “neutral” – so neither inflationary or deflationary. The question is where this neutral rate will be relative to the last decade. Here is a summary of the main arguments.
Arguments for a lower neutral rate
- A continued shrinking in the labour force, coupled with weak productivity growth.
- No significant change to supply issues around savings, given an ageing global population, rising household incomes (particularly in emerging markets) and diminishing risk appetite.
Arguments for higher neutral rate
- Stronger productivity growth emerging from greater use of technology, which could lead to increased demand for investment.
- The transition to net zero. Addressing climate change will require significant new investment.
- Higher public debt. This implies an increase in demand for capital from governments that want to spend more.
- Quantitative easing (QE) is now unwinding, and many households and private businesses are in a much healthier financial position now than they were back in 2008, which could support future demand.
Secular stagnation
Demographic change is likely to be the dominant driver, fuelled by a combination of population ageing and falling birth rates. This points to a lower neutral interest rate and a return to a period of secular stagnation. However, the end of QE and the transition towards net zero, for example, could mean the neutral rate is not as low as it has been for much of the past decade.
World Bank, Population Estimates & Projections, Ages 15-64
Source: Savills Research using Macrobond
The return to “normal” is unlikely to happen quickly. While there are some positive signs that inflation has peaked, central banks continue to err on the side of caution.
Normally, it can take up to two years for the full effects of a change in monetary policy rates to feed through to economic growth. However, the fact that the economy is less interest rate sensitive than it was, with far more borrowed on fixed-rate mortgages and loans, for example, means we expect a very gradual transition.
What does this mean for property investors?
Commercial property prices are typically expressed in capitalisation or cap rates – the net income divided by the value of the asset. These rates have, to a degree, mirrored the rise in interest rates over the past 18 months.
This move has been relatively small, however, making most commercial property a less attractive asset class for investors than, say, “risk-free” long-term government bonds.
In the short term, the longer interest rates remain above the neutral rate, the more likely it is that property yields will continue to rise. But if rates come down relatively quickly, prices may stabilise.
Many investors can temporarily withstand high interest rates, either because they were already on a fixed deal or because lenders anticipating a return of the low-rate environment have found creative solutions to avoid short-term defaults.
If rates settle at a much higher level than we’ve seen for the past decade, however, debt servicing costs will remain permanently high. This will mean higher refinancing costs, or selling unprofitable buildings, potentially at discounts.
A return to a low interest rate environment will alleviate some of these concerns. Nevertheless, investors may need to revise their expectations on the returns available through commercial real estate as risk premiums are likely to be lower in the future than over the past decade.
