How Real Estate Became Hooked On Interest Rate Cuts

It almost seems that the modern real estate industry doesn't know how to transact unless interest rates are falling or historically low.

As inflation stayed persistently high and the investment market remained on ice, real estate investment volumes were subdued in the first quarter, the low figures of 2023 bleeding into the start of 2024. 

“Everybody's waiting for [Federal Reserve Chairman Jerome] Powell to relent,” Starwood Property Trust CEO Barry Sternlicht said earlier this month.  

But it hasn't always been this way. And in an industry with assets totalling $34T, some are questioning why its players feel they can’t function unless central bankers are making favourable policy.

“I’ve been in this industry for 42 years, and for the majority of that time, you’ve had an inverse yield curve where interest rates have been above yields [cap rates],” said Helen Gordon, CEO of UK apartment REIT Grainger. 

The seeds of the market slowdown were decades in the making, taking in obscure financial regulators, a crisis about the future of the eurozone and laissez-faire economic philosophy. Those watching events play out say understanding how the investment market got to its point of stagnation offers insight into what making money in real estate will look like in years to come. 

“It is going to be much harder to make the same returns in the next cycle because rates are not going back to 1%,” Colliers Head of Research and Economics Walter Boettcher said. “Investors are going to have to roll their sleeves and get their hands dirty, building the stock that societies need and repositioning obsolete assets.”

The 300-Year View

The slowdown in real estate investment markets is easy to explain on one level. Q1 U.S. figures of $79B were 16% below the same quarter in 2023, which were in turn half of 2022 figures, MSCI data showed, and the same trend was apparent in the UK. In 18 months, interest rates shot up from close to zero to between 5.25% and 5.5% in the U.S. and 5.25% in the UK.

For real estate investors that use debt, with average yields below interest rates, the income from a deal wasn’t enough to pay the interest, spelling a loss. Investors that don’t use debt figured why buy real estate at a 4% cap rate when a risk-free government bond offered the same return? 

But to really understand the current situation and where it is heading, a longer view is needed. That's because it is hard to underestimate just how anomalous the last 15 years have been when it comes to interest rates and real estate. 

Interest rates dropped steadily from the early 1980s on, MSCI’s Jim Costello said in a recent note. But from 2009, in the wake of the financial crisis and again after the pandemic, central bankers in the U.S. and UK began the process of cutting interest rates to essentially zero, as well as buying bonds through the process of quantitative easing.

That flooded the financial system with more capital, giving banks and investors access to essentially free money. 

In the more than 300 years that the Bank of England has been setting interest rates — and the roughly 200 years that the U.S. has had anything like a centralised rate of interest — the cost of borrowing had never been this low. Even during and after the Second World War, U.S. interest rates were only cut to 1.7% in order to pay for the war effort and rebuild economies in its aftermath. 

“It would have been a brave person who thought, when rates started to come down in 2009, that real estate was about to go on a great run,” said Sabina Reeves, CBRE Investment Management chief economist and head of insights and intelligence. “But then [European Central Bank President] Mario Draghi made a speech in 2012 saying he would do whatever it takes to keep the eurozone together, and you thought at that point, ‘This could be the start of a beautiful uptick.’”

This was the point at which interest rates essentially hit zero, leading to a recovery that saw values across asset classes in most countries exceed previous highs. A fresh slew of interest rate cuts and QE in the wake of the coronavirus pandemic meant 2021 was a record year for global real estate investment. That year saw $1.3T invested globally, according to CBRE, despite much of the world's commercial real estate remaining closed because of the pandemic. 

Meanwhile, from the early 2000s onward, other changes altered the real estate investment landscape and contributed to today's stagnation. 

Regulatory changes for the corporate pension funds that had always been among the biggest buyers of real estate in the UK and Europe made it less attractive for them to hold property assets, Grainger’s Gordon said.

That wasn’t a problem when rates were low and property looked attractive relative to bonds, which brought new investors like sovereign wealth funds into the market. But now, real estate doesn’t look as attractive, and that traditional buyer isn’t there to underpin the market. 

The creation of the securitisation market and deregulation of the banking sector in the early 2000s helped lending to real estate explode, tripling from $1T of outstanding debt held by U.S. banks in 2004 to $3T in 2024. 

Buyers using debt had always been a feature of the real estate market, but never to such a degree: The world’s biggest real estate managers today are the behemoths of Blackstone and Brookfield, which use debt for a big proportion of deals, as do private equity peers like Starwood and Lone Star. 

So when rates go the wrong way, those buyers inevitably draw back. And they won’t be coming back in until things change.

“Debt-backed buyers don’t want to fix in the cost of debt now if they think rates are going to fall,” Colliers’ Boettcher said.

Regulations and attitudes to real estate debt since the financial crisis also laid the seeds of the current market slowdown. 

In the UK, where CRE lending played a major part in the collapse of two of the country's biggest banks in 2009, HBOS and the Royal Bank of Scotland, tougher regulations were enacted after the financial crash that made it less profitable to lend to real estate, particularly development schemes. That led to the amount of debt secured against UK CRE dropping from almost £300B in 2008 to £170B in 2023, according to data from Bayes Business School. 

Those regulations meant that there wasn’t a glut of speculative development lending during the recent bull run, Boettcher said, and lenders in general are not overly exposed to the sector. So while some borrowers are feeling the pain of higher rates, the kind of widespread distress seen in the aftermath of 2008 has not occurred. Lenders aren’t pushing assets onto the market, a process that typically allows price discovery and gets transactions moving again. 

“Our limited partners are coming to us and saying, ‘There must be some distress out there,’” Schroders Global Head of Real Estate Sophie van Oosterom said. “But they aren’t feeling the distress, so where do they think it is? It’s a paradox.”

Even in the U.S., where regulation has been more lax and lending has continued to climb, with regional banks piling up debt to the sector during the recent rise in values, the level of distress is nothing like that compared to the aftermath of Lehman Brothers' collapse. The sector counted less than $100B of distressed loans at the end of 2023, less than half of the 2009 peak, MSCI data showed. That is because loan-to-value ratios didn’t increase the same way as in 2006-2007.

“This time around, the distress isn’t on cash-flowing assets, it’s in the office market, where investors are wary because an asset might have cash flow today, but no one knows where the income is heading,” MSCI’s Costello said. “Borrowers are cutting deals with a servicer or a lender to bypass the foreclosure process and undertaking short sales to show that they’re good actors.”

Back To The Future

The period when interest rates were at historic lows and real estate values were at historic highs was an anomaly, and investors are going to need to learn new ways to turn a profit.

From about 2011 on, making money in real estate was a given, Costello said. The next person in line could always finance a deal at a lower interest rate and, therefore, pay a higher price.

Not anymore. 

Rates are expected to drop in the UK in the summer and later in the year in the U.S., which would kick-start the market. 

“Even if central banks only cut by a quarter point, that will send a message to lenders and borrowers that the trajectory is down,” Boettcher said. “You’ll see the forward curve come down.”

Yet barring an unforeseen economic disaster, rates are not going back anywhere near where they had been for the past 15 years.

“What we’ve been saying is that it’ll be like the early 2000s,” CBRE IM’s Reeves said. “You’ll have inflation at 2% to 3%, interest rates will be 4% to 5%, so ‘real’ interest rates will be 1% to 2%. We called a recent research paper ‘Back to the Future’ because that’s what the period 2000 to 2006 was like.”

Fund managers or investors need to work out what kind of strategy makes sense in this environment and how to create products that can attract money from institutions. A core manager buying safe assets could offer returns of 5% for the past decade. Now the same manager would need to offer 8%. Opportunistic investors looking to make higher returns will need to hit benchmarks of 15% or more, without the wind provided by cheap debt in their sails. 

To do this, investors and owners will need to rely on detailed property knowledge, buying assets, improving the income and running them efficiently, Costello said. Boettcher said building new best-in-class assets in sectors and locations with strong demand can fit that bill, as can tapping into the need to make assets more environmentally sustainable. 

Grainger’s Gordon also pointed to a return of investing strategies of decades gone by.

In a world of higher inflation, real estate can provide a hedge for investors, she said. As long as they pick the right asset in the right sector, buying at cap rates below interest rates could be a viable proposition.

“Traditionally, you had sectors where yields were below rates, like West End offices, [London’s luxury] Bond Street retail and rented residential,” she said. “Rents in rented residential are very closely correlated with wage growth, so if you are seeing wage inflation coming through, that should be good for your asset. It goes back to the fundamentals: Is there demand for your asset?”

Schroders’ van Oosterom said the company is looking to become more involved in the operation of assets, rather than passively leasing space and collecting rent checks.

“You’re looking at anything where you can drive income and link yourself to the success of your tenants,” she said, citing asset classes like hotels with management agreements rather than standard leases, or even offices, which need to be run more like flexible office space than traditional long-lease assets. 

For Reeves, real estate is experiencing a return to normalcy. Given the abnormality of the past few years, that means it will have to reinvent itself. 

“If you look at things in the long term, for decades, for centuries even, real estate has been a good investment,” she said. “But then, every 10 or 15 years or so, it’s bad. But it’s brilliant at finding ways to make itself appealing again.”