The U.S. Federal Reserve is tightening interest rates, the European Central Bank is, too, and that means one thing for investors: paying more to acquire assets.
Investors are watching central banks like the hawks they have become when it comes to policy. The best tool to quell inflation is raising interest rates as a way to suppress demand, but higher interest rates make it more expensive for potential buyers to buy assets and impacts valuations. The ECB raised rates by 50 basis points to zero in July to fight inflation—the first time its raised rates in 11 years—and the Governing Council expects to raise rates again in September.
In the U.S., the Fed this year has raised rates four times for a total of 2.25 percentage points. Markets are pricing in a third consecutive 0.75 percentage point increase at the September meeting and looking for rate cuts to start in the fall of 2023.
Meanwhile, Cleveland Federal Reserve President Loretta Mester told CNBC that she expects interest rates to rise considerably higher before the central bank can ease off in its fight against inflation, even above 4% in the coming months, which is well above the current target range.
"The effect of higher interest rates is already impacting the transaction market," said Michael Bellisario, a senior research analyst covering real estate at RW Baird. "Debt is more expensive and loan-to-value ratios are lower, which have negatively impacted the prices that buyers, particularly private equity buyers, are willing to pay for most assets. Seller expectations are generally unchanged because fundamental performance remains solid. Taken together, the bid-ask spread has widened a fair amount since the onset of the capital markets volatility in May, and fewer transactions are occurring as a result."
The way interest rates move has a significant impact on asset valuations. When interest rates rise, asset prices fall below what they would normally be worth because investors can receive a higher return on a risk-free investment, like less-volatile bonds. Conversely, as interest rates fall, asset prices rise.
In Europe, as Charles Human, CEO of the London office of HVS and the regional president of HVS for Europe, sees it, higher interest rates are still not persuading investors to back off entirely. "In a number of markets," he said, "trading is very strong and earnings are up, which to a greater or lesser degree may be countering the negative impact of higher cap rates. Generally we are seeing a widening bid-ask spread and lower transaction volume.”
The assumption is that central banks are not finished tightening the screws to unclench the inflationary grip. Patrick Scholes, managing director lodging and experiential leisure equity research at Truist Securities, believes so. "Assuming the Fed continues with more aggressive interest rate increases, and it sounds like this will be the case, I would expect hotel asset valuations to fall," he said. "Related, as borrowing costs increase, I would expect pressure on the transaction market."
The current environment is also affecting the hotel pipeline, making developers rethink where to pour in capital, as prices for everything rise. "Rising construction and financing costs, as well as supply chain issues, are dampening pipeline growth for projects in early planning stages, although most hotels under construction are highly likely to open even if on a moderate multi-month delay," Scholes said.
Asset prices fall when interest rates rise because the cost of capital increases. This impacts real estate because it influences cash flow and net income reported on the income statement. Consider hotel acquisitions or new hotel construction: When a business borrows money, it often does so through a combination of debt and equity, the former being higher than the cash initially put in. If the interest rates a company can get in the market are substantially higher than the interest rate it is paying on its existing debt, it will have to give up more cash flow for every dollar of liabilities outstanding when it comes time to refinance. The result is much higher interest expenses.
For HHM, which manages and invests in hotels in the U.S., the Fed's decisions and overall macro-economic factors are having a large impact on investing in commercial real estate.
"We expect valuations to come down somewhat and cap rates to widen as an offset to the uncertain economic outlook and the increased cost of debt," said Shawn Tuli, CFO and head of investment for HHM. "There will be exceptions, of course, for assets and markets that continue to see growth and recovery tailwinds and we think there's still opportunity in such markets and have been finding assets that have pricing power and can express operating leverage through the hospitality recovery."
The overall effect has forced HHM to be more nimble. "As a result of the current environment, the bar is higher for where and how we want to invest capital," Tuli said. "We are adjusting to the new norms and hope to bring creative and productive solutions to willing sellers, similar to our approach in the first year after the pandemic—a time when many other investors were on pause."
In this operating environment, cash is king, and in many instances, companies will hoard it rather than part with it. Here's a scenario that captures the current moment: Imagine having $500,000 in capital to put into a real estate project. In a typical deal, the balance between debt and equity would be 70%/30%. If interest rates increase, the cost of capital increases, too, which means either paying less for the property, which a seller is not likely to do, or withstand lower cash flows.
Higher interest rates also impact cap rates—the rate of return on a real estate investment based on the income that the property is expected to generate. Increased interest rates cause asset values to decline.
“Higher interest rates and lower availability of debt are pushing return requirements higher, therefore increasing cap rates and causing values to fall," HVS' Human said.
Bank Handout
Britain's banks are already seeing the writing on the wall. Some are offering one-off payments to its lower earners, according to a report, to deal with inflationary pressures that are increasing the cost of living.
Nationwide announced a payment to more than 11,000 employees to help with the increasing cost of living. The payment is aimed at those earning £35,000 ($42,300) or less a year, which is 61% of the workforce.
Lloyds announced a one-off £1,000 payment to 99.5% of its colleagues in June, excluding senior management and executives. Virgin Money offered £1,000 to employees earning £50,000 or less in August, and HSBC granted its lowest paid workers a £1,500 cost-of-living payment in the same month.
As inflation negatively impacts many, not so for banks, which reap higher income when interest rates increase. The Bank of England launched its biggest interest rate hike in 27 years on August 4, its sixth rate hike since December 16, 2021.