As interest rate hikes taper off and major economies face the increasing possibility of an economic slowdown, what does the future of the real estate market beckon?
Over the last one year or so, rising interest rates due to aggressive monetary tightening have roiled investment markets across the globe. The real estate sector was not spared, as higher borrowing costs dampened investor sentiment. As the Fed is slowly but surely taking its foot off the gas on rate hikes, it is widely expected that interest rates are going to peak at 5.0% in the first half of this year, and possibly start to decline in the next. Likewise in the other major economies, as supply chain disruptions ease and inflation moderates, as does economic growth, many are also likely to start slowing down their pace of rate hikes this year.
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As the situation unfolds, what fundamental shifts would the U.S., U.K., and Australia real estate markets undergo; if an end to rate hikes were to really materialize this year?
Interest Rates May Peak but Not Pull Back Soon
It is important for investors to first recognize that even though rate hikes are likely to end this year, this does not imply that interest rates will fall imminently. In addition, the real estate market will take time to adjust to any changes, and any impact on the market will be felt progressively. Therefore, I expect any fundamental shifts in the market to only take place possibly in 2024 – depending on the extent of a potential economic slowdown.
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The following are what I believe will happen when that time comes:
Home Prices Should Make Up for Lost Ground
Home prices have taken a huge beating due to rising mortgage rates for most of last year, due to rising interest rates. High costs of borrowing have put a dent in the demand for homes, leading to sliding home prices in many markets. In the U.S., home sales were down 34% in 2022, compared to a year earlier, and December 2022 marked the slowest pace of home sales since November 2010. In the U.K., home prices posted its first annual decline since June 2020 of 1.1% in February this year, and this marked the sharpest contraction since November 2012.
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Meanwhile, in Australia, home prices continued to fall for the ninth straight month in January 2023, down 7.2% from a year ago, as higher mortgage rates bear down on household wealth. If the pace of rate hike slows down and comes to an end soon as widely expected, I believe that the housing market is likely to witness a reprieve and see more stability. This means that the demand for homes is likely to progressively increase and, in turn, push up asset prices.
In addition, existing homeowners will also be able to refinance their mortgages, which will free up cash flow and make it easier for them to keep up with their monthly mortgage payments. This will prevent a potential spate of property foreclosures and benefit the overall health of the residential property market.
Demand for Some Commercial Properties Could Rise
Commercial properties are also likely to benefit from a stop in rate hikes. If interest rates were to peak and be timely enough to stimulate economic growth and steer economies away from the mire of a deep and protracted recession, business optimism could rise and boost investment and rental demand for commercial properties. This implies that an uplift in economic activities could generally lead to an increase in demand for office, retail and industrial properties, among others.
Supported by low vacancy and strong demand, industrial properties in the U.S. and Australia are expected to hold up well against the economic headwinds, and could benefit further if rates were to peak. In the U.K., although capital values of industrial properties are not looking up at the moment, the market could likewise see a turn of events, if rates were to peak.
Demand for office space is more complex as it is also subject to the evolving post-pandemic work models adopted by corporates – a “flight to quality” from occupiers – as well as a shift towards the occupiers’ needs for the environmental, social and governance (ESG) aspects of a workplace. Office demand will hinge upon how well asset owners are able to flexibly optimize their office space for an all-round, high-quality workplace experience for their occupiers to attract and retain talent, as well as whether they will be able to incorporate fit-outs that support the ESG objectives of corporates.
And even though rates are expected to peak in the U.S., U.K., and Australia sometime this year, while benefiting the market, the demand for office assets will be contingent upon the extent of an economic slowdown in these economies. On demand for retail properties: although the easing of pandemic restrictions have seen more consumers return to shopping malls, demand for retail space is likely to continue to be dragged down by slowing economic growth and still-elevated inflation. Even if rate hikes were to cease, the cautious consumer is likely to cloud the outlook for retail properties in the near term, which will affect both rental and investor demand.
Soft Landing or a Deep Recession?
Among other factors, an end to the rate hikes will generally be positive for real estate. But as I know it, the state of the economy also plays a significant role in real estate demand. So, whether these economies are heading towards a soft landing, or a deep recession, will have a significant impact on their respective real estate markets. The good news is that although the U.S., U.K., and Australia are expected to experience a slowdown in fiscal growth this year, these economies are not expected to go into a deep and protracted recession.
On the U.S. economy, Goldman Sachs believes that the U.S. might avoid a recession as the peak impact of the Fed’s rate hikes on GDP growth is already front-loaded and will fade out in 2023. As for the U.K., the International Monetary Fund expects to be the only major economy to contract in 2023, by 0.6%; but expects the U.K. economy to grow by 0.9% in 2024 as the government is carefully navigating various economic challenges and are “on the right track”.
On Australia, the Commonwealth Bank of Australia predicts that despite an economic slowdown across 2023, the economy will be able to avoid a recession, The bank expects the Reserve Bank of Australia to cut rates as early as Q4 2023, and that a tight labor market and strong exports and non-mining investments will continue to help hold up the Australian economy.
Outlook for Real Estate Remains Optimistic
I remain sanguine about the prospects of real estate and believe that the U.S., U.K., and Australia real estate markets will bounce back stronger, especially as a soft landing is expected to occur in these economies. Real estate value also tends to increase over time across various economic cycles. And the fact is, there will always be investment opportunities across different economic cycles that investors could participate in and benefit from, whether it is a real estate equity or debt investment. As a smart real estate investor, it is critical for one to also examine the specific aspects of a real estate deal before one makes an investment – besides taking into account the macroeconomic factors. So, while one keeps a finger on the pulse of the real estate market, be sure that one is fully cognizant of the details of the deal.
