As Warren Buffett said, it’s only when the tide goes out that you discover who has been swimming naked. The ebbing tide in today’s context is the draining away of near free money during the 15 years since the financial crisis. As rising interest rates bring that period of illusory wealth to a close, there have been few places to hide. No sooner has the lid been lifted on one set of interest rate casualties than attention shifts to the next.
First to feel the pain were over-valued technology stocks. They were the first shoe to drop because the stock market is good at looking forward. As soon as it became clear that the Federal Reserve might be serious about tackling inflation, this sector began to underperform. Tech stocks are uniquely vulnerable to rising interest rates because so much of their value today is represented by what they will earn tomorrow. When interest rates are high, investors have less desire to wait around for their returns and they consequently put a lower value on businesses that are reliant on an uncertain future.
There is not a lot the tech companies could have done about this. Falling valuation multiples are beyond their control. More culpable has been the second group of companies to be stung by rising rates - the banks. A bank’s core competence really should be managing interest rate risk because it is in the gap between the prices at which it lends and borrows that a bank should make its profit. SVB’s over-exposure to long-dated bonds, chasing yield by investing in the most interest-rate sensitive of financial assets, was pretty careless.
Fortunately, Silicon Valley Bank’s (SVB) misreading of the bond market looks more idiosyncratic than systemic. To describe the last few weeks as a banking crisis is to overstate things. This is not a re-run of 2008. But that does not mean that banks are out of the woods yet. That’s because, as the interest rate tide drifts further from the shore, the next group of skinny dippers is emerging - commercial real estate.
Like tech companies and banks, property companies are extremely exposed to rising interest rates. Steady rental income and stable valuations are reassuring to lenders, so property investors have never struggled to finance either development or investment. In normal times, and assuming a sensible cushion is maintained between the cost of borrowing and the income a building can deliver, the use of leverage is not a problem. Unfortunately, the abrupt end of a decade and a half of cheap money means the times are anything but normal. Just as many residential mortgage holders are discovering, refinancing a loan that was taken out when interest rates were close to zero is a lot harder when they have risen in just over a year to nearly 5pc.
That’s the first problem facing commercial real estate. Unfortunately, there are three others.
The second problem is the relationship between property companies and the very same smaller and regional banks that are most at risk from rising bond yields and flighty depositors. It is estimated that smaller banks account for around 70pc of commercial real estate loans in the US. And those loans represent 43pc of the assets of small banks versus around 13pc for the largest lenders. The property companies and their banks are like two drunks propping each other up. Rising rates hit property values, which impairs banks’ loans, which makes them less likely to lend, which makes refinancing harder, turning property owners into forced sellers, which hits values and so on. Talk of a doom loop goes too far, but you can see why people are concerned.
The third challenge for real estate investors is that the rising cost of financing their properties and their dwindling access to that finance is being compounded by what, pre-pandemic, would have been an unlikely decline in demand for their product. The arrival of the Covid pandemic significantly accelerated a slow trend towards more flexible working arrangements. The ease with which, overnight, we all learned to work from home, with in many cases no reduction in productivity, means this trend is probably irreversible. In the UK for example, around 40pc of office workers do at least one day a week at home, more than three times as many as before the pandemic. Occupancy across all five working days in London is less than 30pc, half what it was three years ago. Unsurprisingly office values are 15pc lower than they were in 2018.
The final headwind for property investors is also a relatively new problem for the industry - climate change. In the UK, it is estimated that buildings account for nearly 40pc of total carbon emissions, three quarters from running them and a quarter from the construction process. According to Savills, around three quarters of offices fall below the minimum efficiency standards due to be in place by 2030.
Commercial property is an illiquid market in which values can take some time to catch up with reality. In a falling market, sellers can simply sit on their hands and wait. There may be a lack of real transaction data to provide a clear picture. So, the best guide for investors is to look at publicly quoted property funds, where the share price may be a more reliable indicator than the reported asset value.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
