During the pandemic, major property investors became homebodies. Rising interest rates will make it more difficult for them to remain housed.
Investors continue to pour large sums into residential property, just as some home buyers are still willing to pay record prices. According to MSCI data through June 20, they have spent approximately $103 billion on U.S. apartments since January, following an unprecedented $319 billion splurge last year. Institutional investors see it as a safe bet, especially now that remote working has made owning offices riskier.
Rent growth in the United States has recently been extraordinary. According to Harvard University's The State of the Nation's Housing report, released Wednesday, rents for professionally managed apartments will rise by nearly 12% in 2021, more than tripling the average recorded in the five years preceding the pandemic. Year-over-year rent growth remained around 10% as of mid-June.
This has prompted investors to pay exorbitant prices. According to Cushman & Wakefield data, capitalization rates—a common measure of commercial property returns—have fallen to 3.8 percent today, from 4.7 percent before the pandemic. Meanwhile, the cost of debt in the industry is rising, as are landlords' insurance and utility bills.
Buyers in Europe are becoming more cautious. Apartment investment in the region has slowed to $24 billion this year, down from a record $112 billion in 2021. In important residential markets such as Germany, regulations and political tensions over housing costs will most likely limit landlords' ability to raise rents in line with inflation.
In the United States, hopes for further rent increases to offset cost growth appear optimistic. True, vacancy rates in professionally managed rented housing are low, around 5%, giving landlords pricing power. Furthermore, homeownership is becoming increasingly unaffordable, increasing demand for rental housing. The average 30-year fixed-rate mortgage now stands at 5.78 percent.
Even so, rent growth will most likely slow. Green Street, a real estate research firm, predicts that they will rise only 3% in 2023 as affordability tightens. There is also a large amount of new supply on its way. Construction on 1.1 million single-family housing units began in the United States in 2021, marking the first time in 13 years that more than one million new homes were in the works. Apartment complex construction is at a 30-year high.
Some of the unusually high demand from tenants may be a temporary phenomenon related to the pandemic. According to the Harvard report, net new leases for professionally managed flats increased by 713,000 units in the first quarter of 2022 compared to the same period in 2021—more than double the average number in the five years preceding the Covid-19 outbreak. Student loan deferrals, government stimulus checks, and wage growth all boosted young people's finances, allowing them to start new households. This could unravel if tighter monetary policy pushes the US economy into recession.
Stock investors are already far more wary of real estate than private buyers. According to Green Street, shares in U.S. residential real-estate investment trusts are currently trading at a 22 percent discount to gross asset value—a good proxy for where investors believe the value of the underlying real estate is headed. Property values in Europe are expected to fall by 26%, according to European shares.
As interest rates rise, property owners become more reliant on rent growth to deliver decent investment returns on their large purchases. However, there is a limit to how much rent-strapped tenants can afford to pay. Landlords may soon find their properties less comfortable.