April 17, 2023
Rising interest rates weigh on the property sector
German residential real estate is too indebted but is riding on mega trends
In the US, the overheated housing market has led to major imbalances
Despite strong fundamentals, the risk of a property crisis is real

CHART OF THE WEEK: "Residential real estate returns to neutral"


The real estate sector is faltering on both sides of the Atlantic. In 2022, the price of listed real estate companies (REITS) fell by 28% in the United States and 40% in Europe. Residential real estate was among the worst performing real estate sub-sectors while unemployment remained near historic lows and household consumption held up. Since the beginning of the year, residential real estate has been on the rise, driven by market expectations of a potential pivot by central banks towards more accommodative monetary policies.

Rising interest rates weigh on the property sector

Monetary tightening is affecting the whole economy, but primarily those sectors that need to borrow. The real estate sector is highly leveraged due to its high capital intensity. The rise in interest rates, designed to combat post-covid inflation, is increasing its debt servicing costs while reducing asset values.

Moreover, it is not only financing costs that burden the sector but also construction and maintenance costs, heating and electricity costs, taxes etc.

The whole sector is at a standstill and property values have already started to decline (see Fig. 2).

If US apartment prices fell by 13.1% between the market top and December 2022, REITS corrected by more than 30% in the US and more than 50% in Europe over the year 2022: AvalonBay (-37%); Equity Residential (-35%); Vonovia (-55%); Leg Immo (-50%) ...

German residential real estate is too indebted but is riding on mega trends

The fundamentals of German residential real estate are strong, supported by a severe lack of housing supply in urban areas. The ageing of the population and immigration, especially from Ukraine, have further increased the demand for housing in cities (see Fig. 3). However, the legislation introduced to combat excessive rent increases and property speculation is now weighing on investment and housing starts.

Listed real estate companies such as Vonovia, LEG Immo or TAG focus on high growth markets. Despite accelerating rent increases, high occupancy rates, record recovery rates and therefore good visibility on revenues, their share price has collapsed on the stock market since August 2021 (see Chart of the week).

The causes are multiple and concern all actors. Over the last ten years, these companies have taken on a lot of debt, taking advantage of low interest rates to prosper. With the tightening of the ECB's monetary policy, real estate companies must make a choice between paying back their shareholders or strengthening their balance sheets. Most have simply cancelled dividend payments or halved them, like Vonovia, to cope with rising interest costs.

German real estate companies will have to manage their finances closely to ensure that debt servicing does not jeopardise their operational activities. They will probably have to sell some assets to reduce their debt and increase their cash flow. These transactions could be done at prices below net asset value. However, Vonovia's share price is already trading at a discount of almost 40% to its net asset value. In a market where demand exceeds supply, it is unlikely that real estate transactions will take place at such a discount.

The overheated US housing market has led to major imbalances

In 2020 and 2021, under the influence of the Covid-19 pandemic, demand for houses has been strong and supply limited. In this context, property prices have risen to new heights.

But signs of overheating are appearing:

  • Households buy property mainly because they can afford it. The ratio of house prices to disposable income is very effective in determining whether the housing market is over- or undervalued. It has recently reached record levels in the US (see Fig. 4).

  • The housing affordability index is also commonly used (see Fig. 5). It measures whether the average US household has sufficient income to qualify for a mortgage to purchase a standard home. In concrete terms, a housing affordability index of 200 means that the average household income is twice as high as the income needed to obtain a mortgage. Today, at 105, it is only 5% higher.
  • The capitalisation rate is one of the most widely used measures for assessing the profitability and potential return on real estate investments. It represents the return on a property over a one-year horizon, assuming the property is purchased for cash. It provides a quick overview of rental profitability and reflects the trade-off households make between buying and renting their homes. As supply is relatively inelastic, demand will weaken until property prices adjust downwards. It is interesting to note that after 10 years of decline, the cap rate increases rapidly in 2023, from less than 4.5% to more than 5.5% in some recent transactions (see Fig. 6).

Despite strong fundamentals, the risk of a property crisis is present

As cities continue to grow in urbanization, the supply of flats continues to fall far short of the rapidly increasing demand, especially with the aging population. Older people often prefer to live in urban areas that are more accessible on foot and closer to amenities such as shops, restaurants and health care facilities.

Rents are rising with inflation and occupancy rates are, for the time being, remaining at high levels. However, depending on the region and the legislation in place, the gap between returns and the cost of capital is narrowing.

Finally, climate change is leading to higher renovation costs. Recent research suggests that a premium has emerged for buildings that have achieved sustainability ratings from organisations such as the World Green Building Council over those that have not yet achieved these standards. Asset prices will increasingly reflect the level of capital expenditure required to meet standards, whether these climate-related improvements are imposed by legislators or result from changing market preferences.

Real estate companies, REITS and households have benefited from extremely low borrowing rates over the last fifteen years. The increase in debt service is therefore naturally reflected in the value of property.

Listed real estate companies will have to sell assets to reduce their debt levels, but it is best to avoid selling under constraint. With maturities staggered over time, there is little room for individual players to reduce their debt. Real estate is an illiquid asset, and it is not only real estate companies that potentially have to sell assets. Insurance companies and mutual funds may also need to increase their liquidity levels and quickly dispose of their real estate investments, at the risk of accepting a discount if the need arises.


When the real estate sector is in trouble, it tends to deepen financial crises because of its close link with banks and its financing needs. The sector is therefore to be watched closely. Rising interest rates, labour shortages, inflation, stricter regulations on environmental and climate standard, are all factors that are likely to weigh on property prices. In the long term, the sector tends to appreciate with inflation, especially as demand continues to outstrip supply.