Similar to business cycles or stock markets, real estate is also subject to up- and downtrends, which can be driven by a number of factors, namely demographics, economic growth or recession expectations and, most important, interest rates. Over the past decade and a half, the consistently low level of interest rates – which in some instances have even turned negative – is one of the main reasons behind the current real estate boom. Among the top investors in both residential and commercial real estate, we find, in fact, large institutional organisations – insurance companies, pension funds, etc. – seeking low risk and steady returns. But the ultra-low regime of interest rates is expected to end, eventually (the US Federal Reserve has already hinted at rate hikes in 2023), an event that, when coupled with the socio-economic effects of the pandemic and, not least, climate change, will certainly have an impact on the global commercial and residential real estate market.
Real estate is indeed an asset class of its own, just other financial instruments, and therefore the subject of interest not only for market experts, but also to academics, like Finance professor Alberto Plazzi and Economics professor Lorenz Kueng, both at the USI Faculty of Economics and faculty members of the Swiss Finance Institute. Plazzi and Kueng share a few insights on the trends and risks in the commercial and residential real estate markets, which concern investors, lenders, and homeowners alike, in the wake of the pandemic and climate change, but also of digital innovation and interest rate expectations.
How does real estate differ from other classes of assets, such as stocks or bonds?
«From a homeowner’s view, property is not only an investment, but also a product of consumption», says Lorenz Kueng. «Real estate does share many of the characteristics of stocks and bonds, in particular with respect to price swings and the risk premiums of equity. Nonetheless, one dimension where real estate differs considerably from stocks and bonds is the general absence of possibilities to short the market or to mitigate price risks».
So, similar to financial markets, is real estate also at risk of “bubble-to-burst” events?
«High leverage possibilities and the relaxation of lending standards, as recently observed in the U.S., mechanically lead to the risk of amplifying any potential shocks which may occur», says Alberto Plazzi. «Due to the low liquidity which typically prevails in the real estate market, as well as the quantity and quality of data available, we have limited oversight of what the current market price is and in which direction it is heading. The direct consequence is that it takes considerably more time to learn if a real estate transaction was a good one or a bad one, in comparison to trades on a publicly listed market, like for example stocks. In addition, because of the virtual nonexistence of hedging contracts and the fact that it is difficult to break down individual properties, we have very limited means of diluting an investor’s price exposure. The combination of these factors means that real estate investments are typically risky».
What have been the recent trends in real estate markets?
«Real estate prices worldwide have gone up significantly over the past 10 and more years, but we can observe the same trend in the equity market. I believe the key driver behind this rise is the lowering of interest rates, which has mechanically pushed both real estate and equity prices up, and has pushed investors to go one step further, in terms of risk, when hunting for yield», says Prof. Kueng. «With concerns to the Swiss market, data show that the house-price-to-rent ratio (which is similar to the price-to-dividend ratio in the equity market) and the house-price-to-median-income ratio have both gone up over the past 15 years, suggesting the possible creation of a price bubble. We must nonetheless look at these ratios with a critical eye, as data limitations are one of the key characteristics of the real estate market. Market heterogeneity is widespread, and we typically don’t observe the rental and sales prices of the same house simultaneously».
Do technological innovations in finance have the possibility of disrupting the real estate market?
«I don’t believe that financial technology (FinTech) can disrupt the real estate market per se», says Plazzi. «Its tangible brick-and-mortar dimension is here to stay, and experience shows that the possibility of developing financial instruments, such as options and futures, for real estate are largely limited. But I do believe that FinTech will nonetheless impact some parts of the real estate market».
The commercial and residential real estate sectors are responsible for a combined 17.5% of all global greenhouse gas emissions. How will initiatives to curb such emissions impact the real estate market, and how should they be designed?
«The real estate market has a huge potential to play in terms of curbing greenhouse gas emissions, in comparison to, for example, agriculture and forestry. The technologies to lower greenhouse gas emissions in the real estate sector already exist (i.e., insulation, solar power panels, energy storage solutions, etc.)», replies Kueng, who adds, «I am quite optimistic that the real estate sector will adopt the appropriate technology and adapt rapidly. Government intervention, with respect to mandatory disclosures on emissions, could help accelerate this transition. Another nice point here is that the transition is not concentrated in the hands of a few players, but is largely in the hands of billions of homeowners».
On this subject, Prof. Plazzi comments, «Data indeed show that energy efficiency labels have a clear impact on real estate prices. Public mechanisms, in particular taxes and subsidies, need to push harder to accelerate the energy transition of the real estate sector. I can imagine a dynamic tax system, similar to the one that exists regarding car emissions, for example, where owners of properties whose energy efficiency falls below some threshold would face an additional tax. Such a system would launch a race among property owners to invest in energy-efficient solutions, as the market’s average efficiency would mechanically improve over time».
What does tomorrow’s mortgage market look like, and how should banks – and institutional investors – adapt to it?
«Interest rates and mortgage rates alike are not expected to increase in the short run, nor in the medium run», says Plazzi. «With such low rates, margins tend to be razor thin, meaning that the scope for competition should not be fierce. Banks should focus on maintaining good relationships with their existing clients and monitoring their credit risk. As for institutional investors, and in particular pension funds, the focus is typically on the requirement to fulfil given investment quotas. Today’s financial environment, characterized by low interest rates and high real estate prices, is radically different from the one which prevailed 15 years ago, so from a general perspective, diversification is key when constructing a portfolio, which should occur not only across assets, but also across industries and geographic areas. In the specific case of real estate, we need to account for the age of the property, as increases in environmental scrutiny regarding the real estate sector will likely push the price of inefficient properties – which are numerous in Switzerland – downward. This gap, in terms of energy efficiency, between old and recent buildings, will generate a major price discount for old buildings and could ultimately pose a threat for pension funds».
As mentioned, real estate is an asset class for investment. Also for homeowners, as such, for whom a residential house is typically the largest asset owned by a household. What does this mean in terms of portfolio diversification?
«Overall, investing primarily in real estate means that the household’s financial risk is poorly diversified and, worse, that this risk is highly leveraged», says Lorenz Kueng. «U.S. data show that real estate prices are positively correlated with wages, so when the economy is booming, rents go up and so do wages. This correlation implies that renting provides a natural hedge to changes in economic output – a hedge which homeowners give up. Interestingly, financial advisors tend to omit the hedging benefit of renting when they analyse the financial risk individuals are facing. Whether these US results apply to the Swiss market remains an open question. Nonetheless, many people believe that the risk in real estate is similar to that of government bonds, which is shockingly wrong. Real estate prices have dropped in the past and will drop again in the future».
What would be your word of caution for households?
«Owning real estate obviously has large benefits, but it also comes with risks, which people tend to minimize. Households need to run the numbers and go beyond the figures of rent and interest payments; they need to be disciplined, when it comes to effective maintenance, and also consider debt amortization beyond the minimum that is required. Buying property is both a financial decision and an emotional one, which means that we need to view real estate decisions from multiple perspectives», concludes Prof. Kueng.
The complete version of this interview, which includes also the comments of market and industry experts, is available in the June 2021 issue of SFI Roundups.
What is the Swiss Finance Institute?
Swiss Finance Institute (SFI) is the national centre for fundamental research, post-graduate (PhD) training, knowledge exchange, and continuing education in the fields of banking and finance. SFI’s mission is to grow knowledge capital for the Swiss financial marketplace. Created in 2006 as a public–private partnership, SFI is a common initiative of the Swiss finance industry, leading Swiss universities, and the Swiss confederation. www.sfi.ch
