Review 86th Swiss Real Estate Talk

Moderator John Davidson, a professor at the Lucerne University of Applied Sciences and Arts, outlined the big picture in various economies at the start of the well-attended 86th Swiss Real Estate Talk at Zurich's Metropol restaurant: In Europe and other parts of the world, inflation has initially been driven by rising energy prices. In the U.S., an initial wave of inflation is already spreading further - a wage-price spiral has already begun here. "But does inflation have to be bad per se?" was the moderator's opening question.

Obviously, it always depends on the environment, i.e. wage development, demand and the economy. Many other aspects also play a role, such as the question of the enormous expansion of the money supply in most Western economies and its consequences. John Davidson began by pointing out how difficult it is to make forecasts. While leading economists and banking houses were still denying the thesis of the "interest rate turnaround" as recently as January of this year, the world looked very different within a very short period of time. And the "specter of inflation" cited in the palatable headlines returned much faster than expected.

Is the thesis correct?

Economist Francesca Boucard, Head Real Estate Research & Strategy at Swiss Life Asset Managers, emphasized that real estate is fundamentally an inflation hedge. The thesis is justified in itself, Boucard told the packed auditorium - "but don't expect overperformance." In a direct comparison with other asset classes such as equities and bonds, real estate did indeed perform well in the long term. But there are also clear indications that put an overly naive belief in inflation protection into perspective, according to Boucard: "This starts with the fact that not all rental contracts in the operating business are indexed 1:1 with inflation. Depending on the details of the contract, the sector, the market situation, and the economic cycle, the result is a very different assessment.

Another initial conclusion is that, adjusted for inflation, the capital values of real estate in various sectors such as retail, office and industrial have fallen. This is shown by figures for the UK. For the Swiss market, too, it is clear that there were times when capital values and rents were able to keep pace with inflation to some extent. But the thesis is far from valid for every period under consideration. Demand for real estate as an investment fluctuates; there are also structural changes. Rising discount rates and more expensive financing costs also have their effect, of course.

Farm and Timberland as a niche

Christos Tsaravas from Manulife Investment showed the positive effects that investments in niches offer. For example, those who invest in U.S. farmland and Timberland over the long term benefit from a positive diversification effect. The correlation with other asset classes is low. Forest, farmland and timberland generate stable returns and positive performance with low fluctuations. Especially as an admixture in a classic asset strategy, such investments pay off: Returns in the portfolio are higher overall, and the risk-return profile improves. Tsaravas also provided concrete figures to show that the returns from Farmland and Timberland over a period of 30 years are significantly higher than inflation. Tsaravas went on to say that interest in this niche has recently increased significantly: European investors in particular were using these instruments not just for diversification purposes, but also to implement their decarbonization goals. "Most companies have defined their longer-term CO2 emissions targets in their strategy," Tsaravas said. That's because forests and farmland contribute significantly to reducing greenhouse gases in environmental balance sheets.

For Daniel Brüllmann, Head Real Estate DACH at UBS, inflation and interest rate risks are currently only one of several challenges for the industry. Investors also have to deal with changing tenant needs, the transition to a sustainable economy (CO2 reduction path, etc.) and the still very competitive transaction market. "We don't see any inflation in transaction prices," Brüllmann said. More restraint is noticeable at the edges of the market at best, but overall net yields in central locations in Switzerland are still extremely low, he said. According to Brüllmann, this is the first time in a long time that the industry has had to adjust to an inflationary environment. What is clear, he said, is that real estate offers interesting potential - both in an environment of very low interest rates and higher interest rates. "We see the problem more in the transition phase from low to higher interest rates," says Brüllmann. While rents in Germany, for example, can currently be adjusted relatively quickly to the changing cost situation, the Swiss housing market functions differently, he says. Brüllmann anticipates a certain transition phase in which discount rates for property valuations could already rise, while regulation or the reference interest rate for residential rents leaves no room for maneuver.

Focus on rising market rents

Zoltan Szelyes, renowned analyst and CEO of Macro Real Estate, showed specifically how family offices position themselves in the context of higher inflation. In his opinion, net income growth and the positive development of market rents are gaining in importance. The continued preference of Swiss investors in the area of multifamily properties should be questioned, Szelyes said, as this apparently "underestimates the risks in the market." In times of inflation, this "fixed-income part" can perform poorly; the risks associated with investments with very low net yields are increasing, he said. In fact, financing costs are currently going up significantly; higher discount rates are putting pressure on valuations sooner or later, and rents cannot be raised, or only with a delay, despite inflation because of the sluggish reference interest rate in Switzerland. Other classic investments such as U.S. offices are also more likely to be avoided because of high capex costs, the analyst says. Szelyes is therefore focusing on other assets that promise growth and rising cash flows: for example, unlisted real estate funds, hotels or space for life science.

Conclusion

Finally, moderator John Davidson asked the panel for their general assessment of the inflation trend and net initial yields. Opinions vary widely as to whether or not inflation has already reached an upper limit. With regard to prices and net yields, however, a clear consensus emerged on the panel: the expert and the experts are unanimous in their view that the bottom has now been reached for net yields. The discount rates for valuations will probably rise again - the only question is how quickly this will happen.

The 87th Real Estate Meeting will be held on September 20, 2022.