Real estate markets in focus: How interest rate hikes affect the price-value ratio

For more than a decade, real estate investments were considered a stable supplier of cash flow and a central component of institutional portfolios, supported by increases in value that were favoured by an expansive monetary policy and a stable economy. Nevertheless, there have always been warnings against price excesses, as price and value do not always match: "Price is what you pay, value is what you get." With the interest rate turnaround, the environment for real estate investments has changed fundamentally. Rising financing costs, economic uncertainties and global risks are weighing on the market. The impact will vary by real estate asset class, and investors will need to adapt their strategies to the new interest rate landscape.

In order to understand the influence of thematic investing on prices and values, risk-return analysis in the context of portfolio and capital market theory is central. According to Markowitz, portfolios are assigned a risk-return profile, with risk-averse investors avoiding higher returns in favor of lower risks. The CAPM expands this to include the assumption of efficient markets, while Fama and French, as well as Carhart, introduce additional factors such as market capitalization, valuation multiples, and momentum. For real estate, specific premiums such as illiquidity, lack of transparency and downside risks are crucial. While the German income value method estimates prices based on past transactions, the international DCF method takes into account uncertain cash flows through a risk-adjusted discount rate. All real estate-related risk premiums should be included in the valuation.

A successful real estate investment is based on two core parameters: cash flows (CF) and cost of capital (k). Long-term stable cash flows ensure profitability, while the cost of capital – represented by the discount rate – reflects the risk assessment. Adaptability to structural market changes is essential, as cyclical market fluctuations and long-term developments can significantly affect property values. The ongoing low interest rate phase and QE programs have benefited the residential sector, which has become particularly attractive for institutional investors due to high demand, multi-tenant structures and low vacancy risks. The share of the residential segment in the transaction volume rose from 16% (2007) to 25% (2020). At the same time, retail lost importance, while logistics established itself with over 15% market share. Since 2022, however, the interest rate turnaround has led to a drastic decline in transaction volumes and an increase in the cost of capital. Higher interest rates result in greater discounting of future cash flows and thus lower real estate values. Buyers and sellers are finding it increasingly difficult to find each other, as a price-value identity is more difficult to achieve.

The theories of Markowitz and Fama, based on the assumption of perfect markets, are used for the quantitative postulation of risk premiums. Since imperfect markets dominate in practice, the market price does not always correspond to the value. The real estate asset class "Wohnen Berlin" is examined as an example, as it is becoming increasingly relevant and allows well-founded assumptions to be made about cash flows (CF) and cost of capital (k). While CF can be planned well in the long term, determining the exact discount rate remains an almost impossible task. However, representative survey results from institutional investors provide a practicable basis.

The basis is the risk-free interest rate according to CAPM, usually derived from the interest rate on 10-year government bonds. Its development is influenced by monetary policy measures and reflects inflation expectations as well as the time value of money. In Germany, the current yield is currently 2.2%. After the interest rate rises of recent years, a plateau seems to be establishing. A level of 200 basis points is assumed for the analysis in order to take into account the structural interest rate turnaround, demographic change and long-term investment goals of institutional investors.

The market risk premium in the CAPM model is determined using the volatility of cash flows (CF), with a typical corridor of 50 to 300 basis points and a median of about 100 basis points. CF volatilities vary by asset class and city type: Class A cities and commercial real estate show higher values, especially "office" and "retail", which require a risk buffer due to structural challenges. For "Wohnen Berlin", an imputed premium of 140 basis points is applied.

According to the approaches of Fama, French and Carhart, real estate-specific risks such as liquidity risk (lack of buyers in illiquid markets) and transparency risk (insufficient data for valuation and price determination) should be quantified. Both risks increase more strongly in smaller markets. For "Wohnen Berlin", 30 basis points are to be set as risk premiums in each case.

Institutional investors may be subject to an asset illusion, as the increase in real assets is not accompanied by increased purchasing power or better consumption opportunities. This illusion leads to an underestimation of risks, especially for downside scenarios. The risk premium is intended to reflect market value increases and potential setbacks, such as those recently made visible by the interest rate turnaround. For "Wohnen Berlin", the premium fell from 140 basis points in 2020 to currently only 10 basis points.

The discount rate for "Wohnen Berlin" 2024 is 410 basis points, based on the risk-free interest rate and risk premiums. With a long-term cash flow of EUR 13.4/sqm, this results in a valuation of EUR 3,780/sqm. The price-to-value ratio (PW) is just above one, indicating a fair valuation at the end of 2024. Between 2010 and 2017, a PW below one indicated an undervaluation, making investments attractive. From 2018 onwards, however, an overvaluation became apparent, which intensified until the interest rate turnaround. The values corrected, and a fair market status will be achieved again in 2024. Megatrends could justify a real cash flow growth rate in the future, which can be mapped in the Gordon Growth model. With stable base interest rates and moderately high inflation, the price peak of 2022 (EUR 4,850/sqm) is not expected to be reached again until the end of the decade. The decisive factor is the absence of serious market disturbances. Institutional investors should use scenario techniques to better assess future developments.

The interest rate turnaround has fundamentally changed the dynamics of the real estate markets. Rising financing costs, increased cost of capital, and greater discounting of future cash flows lead to lower property values and make price-value identity more difficult. This requires investors to accurately assess the risks and opportunities in an increasingly challenging market environment.

Institutional investors should take a systematic approach to valuation by taking into account risk-free interest rates, market volatility and property-specific risk premiums, such as liquidity and transparency risks. The application of the DCF method provides a sound basis for adequately mapping cash flow stability and the cost of capital. At the same time, the consideration of downside risk makes it clear that market adjustments due to unexpected interest rate and price developments must be regularly integrated into the strategy.

The price-value ratios in the "Wohnen Berlin" segment are an example of how fair valuations are returning as a result of the interest rate turnaround. Strategic premises should aim to use detailed scenario analyses to cushion risks and identify potential value increases at an early stage. Investors who retain flexibility and adaptability are better positioned to capitalize on market opportunities and achieve long-term investment goals.