Is the real estate industry facing a new 2007?! – What are the implications of war, inflation, and rising interest rates?

Amidst inflation, the war in Ukraine, and recession fears, financial markets are more precarious than they have been in a long time. Some economists identify dangerous parallels to the 2007 financial crisis, while financial market expert Kenneth Rogoff even warns of a 'perfect storm' on the horizon.

The intricate connections between the real estate sector and financial markets mean that an increasing number of real estate stakeholders are now closely monitoring developments in the financial economy. Elevated construction costs, rising credit rates, and cautious investment markets are merely a few of the significant repercussions that a potential market downturn could trigger.

But what exactly do real estate companies need to prepare for, should such a scenario occur?

We have summarized the five most probable impacts for you:

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1) High inflation leads to high interest rates

Everyone is feeling the impact of rising inflation. To counteract this, the FED and ECB began raising key interest rates mid-year. This, in turn, has direct implications for the real estate sector: Higher interest rates have significantly increased financing costs. Debt capital costs have nearly tripled during the first three months of the interest rate hike. Even if initial statements from central bank circles suggest that interest rate increases will be very moderate throughout the rest of the year, their impact on the industry should not be underestimated. Due to the restraint of established capital providers, some market experts even anticipate measurable effects on real estate prices and, consequently, on the supply-demand relationship.

Initial impacts are already noticeable, particularly in the residential segment. A growing number of individuals can no longer afford to purchase property and are compelled to opt for rental housing. Consequently, higher-income housing seekers are entering the market, which is likely to drive demand for high-quality residential space in the short to medium term.

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2) Inflation: Merely one driver of housing costs

Beyond everyday consumer goods, inflation is also significantly impacting rental prices. Index-linked rents are particularly affected, as they are not bound by local rent indices but are instead directly tied to inflation. These types of rental agreements are especially prevalent in metropolitan areas; for example, the Hamburg Tenants' Association estimates that up to 50 percent of newly concluded contracts in the Hanseatic city are index-linked. This increased financial strain disproportionately impacts low-income households.

Beyond inflation, escalating energy prices are becoming a critical issue. In some regions, these prices have surged by over 35 percent since May of this year compared to the previous year. Consequently, the financial burden on households that must dedicate a substantial portion of their income to energy costs, and already possess minimal reserves, is continuously intensifying. The property owners' association Haus & Grund estimates that households could face additional cost burdens exceeding 80 percent. Following two years of the COVID-19 pandemic and limited economic recovery, this situation could precipitate severe challenges.

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3) Energy costs are becoming a problem for unrenovated properties

Not only private households will face significant problems due to energy costs in the medium term; their increase will also impact real estate valuations. While ESG-compliant buildings may significantly benefit, older, unrenovated properties will particularly face devaluation due to rising prices. Consequently, future rents will likely be much more closely tied to the age and modernization status of properties.

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4) Investment markets are stagnant

Activities in the investment market typically serve as a clear indicator of an impending crisis. As risks escalate, so does the caution among more conservatively-minded capital providers. For instance, the real estate services firm Savills reported a significant decline in investments across both residential and commercial properties in May 2022, a trend unprecedented in the last decade.

This is likely due to increased financing costs. Investors are compelled to recalculate their financing plans and adopt a more prudent and risk-aware approach. Institutional investors, in particular, are expected to favor secure investment opportunities in the medium term, a trend previously observed during other economic downturns.

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5) Material Scarcity

Discussions about interest rates and energy prices are justifiably in focus right now, but all the associated problems recede into the background when materials are missing on construction sites. A significant portion of the reinforcing steel used in Germany previously came from Ukraine, Belarus, and Russia. Since the start of the war, this supply has been lacking, reportedly leading to initial construction halts.

Furthermore, high energy prices render production uneconomical. Price increases of up to 17 percent make project calculation increasingly challenging. In the worst-case scenario, projects have even had to be entirely canceled.

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Conclusion

War, inflation, rising interest rates, material shortages – the list of current challenges is extensive. Simultaneously, the real estate industry must adapt to megatrends such as digitalization, sustainability, and demographic change.

These factors will ensure that fundamental considerations, such as location, demographic dynamics, and building quality, will once again be central to investment decisions, potentially determining a project's profitability in the medium term.

The industry must adapt to evolving market conditions, and crucially, ESG-compliant projects present promising investment opportunities.

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