Rising finance costs put yields under pressure



Will the rising cost of debt finance have an adverse impact on the appetite to buy property?

According to Savills, the increasing debt cost comes at a point in the cycle when yields are historically low, meaning that the all-in-cost of debt stands at the same level as prime entry yields for many markets across the UK and Europe.

These rates have risen sharply over the last 12 months, with investors factoring in higher debt costs into their financial models. Inevitably, for those leveraged buyers focused on income-based investments, returns are coming under pressure.

Despite the rise in interest rates, Savills highlights that rates remain low by historical standards and expect borrowers will adapt to a new interest rate environment as they have in previous cycles.  The firm suggests that the availability of debt is arguably more important to borrowers than debt pricing itself, in order to maintain a liquid market.

Savills has recorded over 400 active property lenders comprising a myriad of different debt providers, up from 240 in 2018. The growth of non-bank lenders continues to evolve, with debt strategies as a form of real estate investment, now more understood with a focus on growing assets under management. Despite the number of new entrants, meaning that banks now make up less than half of the active lenders by number, they are still the dominant players in the property finance market.

Nick Harris, head of UK and cross border valuation at Savills, commented: “Borrowers now have a greater choice of lenders than ever before as they navigate the complexities of the real estate finance market. This is likely to emphasise the importance of debt advisory, with virtually everything financeable, at a price. Lenders are likely to remain focused on asset selection, quality of sponsors, and the cashflow story. Future Capex requirements are a challenge for both lenders and investors at present, with the market witnessing unprecedented levels of cost inflation, resulting in financial models coming under increased scrutiny.”

The factors that remain in focus for many lenders are a flight to quality, concern around future obsolescence, and the cost of meeting EPC requirements, particularly in the commercial sector. Whilst leveraged buyers will be factoring in the changes to the cost of debt, which could impact pricing for some assets, there remains a significant weight of money targeting real estate. Lenders will likely examine rental growth prospects to support their customers in paying keen yields, with that growth arguably coming from those sectors that are short on the right stock.

Addressing the agile working debate and its impact on the office sector, Savills confirmed that currently firms are taking as much, if not more, office space but there has been a ‘herding’ towards green and prime buildings responding to ESG and staff demands.

Indeed, a supply demand imbalance will push the price of green offices up ensuring continued rental growth at the prime end of the market in both London (where 61% of office take up has been in BREEAM Very Good or above properties) and the regions.

The remaining stock will create a market for developers in prime locations. Logistics, the most undersupplied sector with record low vacancy of 2.7%, will see rental growth across prime and secondary markets.

Finally, retail rental growth may not be enough to justify the current cost of borrowing but this will not deter some investors who see the sector as a cyclical play due to its current significant high yields.

Mat Oakley, Savills head of commercial research at Savills, comments: “Ultimately the shortage of stock in selected sectors will maintain rental growth and insulate against the cost of rising debt, and with 40% of investors not needing to borrow at the point of acquisition, some will be able to play the market at yesterday’s prices.”

From a residential perspective, Savills notes that the prospect of further interest rate rises and cost of living pressures is likely to put a brake on house price growth in the second half of this year.  However, the low levels of publicly marketed stock, combined with the extent to which existing borrowers have locked into fixed rates or had their mortgage affordability stress tested, will limit the prospect of price falls over the next 18 months.

Last week Savills released revised price forecasts for the UK mainstream housing market, suggesting +7.5% growth in 2022 will be followed price a -1% softening in prices in 2023 and low single digit house price growth in the following three years.

“From both a consumer and industry perspective, a lot depends on whether – following its consultation on dropping affordability stress testing – the Bank of England relaxes mortgage regulations and shifts its focus more towards the energy efficiency of the housing stock lent upon.  The former would unlock additional capacity for price growth, while the latter has the potential to make the availability and cost of mortgage debt more dependent on the EPC rating of a borrower’s property” says Lucian Cook, Savills head of residential research.

This more muted outlook for the residential market sits against the context of an increasing uncertain policy environment for housing delivery.

“The loss of Help to Buy combined with a shift in the government’s focus on housing, is expected to put pressure on development funding opportunities in the residential space,” said Gaby Foord, associate director in Savills’ research team. “Increasingly, it looks like to future of Build to Rent will be crucial to lenders meeting their lending aspirations.  Higher costs of debt may put pressure on the loan to values which lenders can offer in this space. However, the sheer scale of investors aspirations means the sector will present a strong lending opportunity as it matures and diversifies.”

Savills concludes across all sectors the search for stock that is immune from economic pressures will be a priority for the year ahead not withstanding increasing pressure to consider ESG credentials, which will be increasingly scrutinised, and potentially regulated in the residential space.

 

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