Interest rates, financialization and 'Buy-to-Rent'
The Week in Housing 01/07/22
Everybody is talking about market volatility at the moment. We appear to be entering into a new economic cycle of high interest rates and inflation. This brings major risks, especially because the long era of cheap money and quantitative easing has pushed asset prices and equities to what many people feel are unjustified levels.
What kind of risks does this pose for our housing system, especially the institutional PRS/Build-to-Rent (BTR) sector?
One reason why this question is not really being asked in the Irish context, at least in the debates I am privy to, is that the current housing cycle has not been driven by cheap credit coming from the mainstream banking system. After the crash in 2008 banks were regulated quite tightly to deal with systemic risk. The fact that the current housing market, in Ireland at least, is not inflated by abundant mortgage credit or high risk developer finance could lull is into a false sense of security.
But there is a danger of becoming generals fighting the last war here.
On closer inspection, there are important lessons from the global financial crisis for today. The last property bubble was a consequence of plugging Irish real estate into global flows of capital. The form it took was Irish banks borrowing big form international banks. The drivers were Eurozone integration and deregulation of the international financial system. The lesson we can take from this is that linking local housing markets to global flows of finance produces, at least potentially, new systemic risks that don’t become apparent until conditions in the global financial system change.
The current financialized real estate cycle is not a domestic bank credit bonanza. Instead, it primarily takes the form of international institutions investing in institutional PRS/BTR. But ultimately it is still about plugging local real estate into global flows of capital. Consequently we should be attentive to the potential risks that may be associated with this form of financialization.
In a 2016 Dublin Inquirer piece, I argued that institutional investment in Irish real estate ‘subjects it to even more intense forces in the global financial system, such as US interest rates’. Today, we could be about to see those risks becoming a reality, as US interest rates, as well as those of the ECB, BoE and others, are rising sharply.
What got me thinking about this was a recent episode of the Odd Lotts podcast featuring Jim Chanos, a hedge fund investor and self-professed ‘short seller’. That means he specializes in identifying assets that are overvalued. Referring to the US context, one set of assets he identified in the Odd Lotts interview was REITs and real estate assets in general. He made the point that to spot overvalued assets you need to look at the relationship between share/asset prices and the underlying fundamentals in terms of capitalization rates and business model etc. Intriguingly, he also said you want to look at assets that have ‘a narrative’ around them that is leading to over confidence and pumping up valuations. Examples here would be Crypto or Fintech.
This got me thinking about institutional players in Irish real estate, REITs, etc. I am no expert in analyzing the financials in the sector, so I will leave that to others. But I do have concerns about the narrative around BTR/institutional PRS. That narrative goes something like this:
· Long run demographic and housing demand changes mean there is robust demand for rental housing over the medium to long term;
· The PRS is ‘counter-cyclical’ in the sense that if incomes and employment are stagnating/falling, more households struggle to buy or defer buying, and thus demand for PRS may increase during a recession or downturn;
· PRS assets can thus be considered ‘defensive’, i.e. you can diversify away from potentially overvalued stocks like Tech stocks into real estate to protect against potential future volatility;
· The traditional problems of PRS housing, i.e. the fact that housing is a lumpy, spatially fixed, illiquid asset, have been overcome by financial structures such as REITs (which turn income streams from individual units into globally tradable assets).
The Covid-19 pandemic copper-fastened this narrative as institutional PRS weathered the storm very well and bounced back very quickly (I discussed this in more detail here).
There are a number of aspects of this narrative that I find concerning.
First, it is not clear that PRS is counter-cyclical. Rents are at record highs and thus must surely be vulnerable to employment and income shocks. For example, in the Irish case we could look at some of the challenges in the Tech sector. There appears to be near universal agreement that tech stocks are overvalued and a number of tech companies globally have announced hiring freezes. Tech employees are likely to be particularly effected by the shift towards Work from Home, which may mean fewer tech workers locating in Ireland. The global tax environment is also changing in ways that could affect the tech sector in Ireland. (Although I should note that at the moment FDI is performing very well in Ireland).
Second, it seems problematic to draw conclusion about the ‘counter-cyclical’ and ‘defensive’ nature of institutional PRS/BTR from the Covid-19 pandemic. This is because during the pandemic Government rolled out unprecedent employment, income and housing supports.
Third, there is considerable policy risk as many countries have begun to introduce legislation to constrain institutional PRS and there is quite a lot of public hostility to the sector. Many countries, including Ireland, Scotland, Germany, France, Spain and some states in the US have introduced rent regulation over the last few years, for example.
The fourth, and most important, concern I have is interest rates. The entire wave of financialization associated with the PRS has taken place on the basis of, and been driven by, the ultra-low interest rate environment. There has been an enormous spending spree on institutional PRS assets internationally, especially in Europe and the US.
This raises the important question of what impact increased interest rates will have on asset values and share prices in the Institutional PRS/BTR sector? Last week’s ESRI Quarterly Economic Commentary looked at this issue in relation to housing in general, and argued that under a 0.5% rise in ECB rates houses prices would be 2 per cent lower than what they would be under the existing mortgage rates (the Inside Business podcast also had an interesting episode on Irish house prices this week). This research focused on the household/mortgage market, but what might a similar exercise reveal about the institutional PRS/BTR sector?
Additionally, what will the impact of higher interest rates be if they occur in tandem with a recession, i.e. declining incomes/employment?
This is an important question for policy makers. Someone needs to figure out what institutions will do if their rental incomes, share prices and/or asset prices fall, and how their model is affected by higher interest rates.
But we also need to think here about a potential opportunity.
Earlier this year, the Greens/EFA in the European Parliament published a report on institutional landlords and put forward a radical proposal: a European Housing Fund that would ‘function as a countercyclical force that ring-fences the collapse of housing asset bubbles that typically result in the transfer of housing units from local private/public ownership into institutional portfolios’ (I wrote about the report here).
If we do end up in a situation in which institutional PRS assets are devalued it would make sense to use that as an opportunity to purchase them to convert them into non-market housing of some sort.
The arguments presented here are somewhat speculative. I don’t claim to be an expert on investment assets or monetary policy. Nevertheless I think the concerns raised merit consideration, and I hope that others who have some of the expertise I am missing might give them some thought.
This is the last issue of The Week in Housing for a while as I’m taking a summer break for July and August. This will give me some time for annual leave and catching up on research and reading. Thanks again to everyone who has been reading and sharing the newsletter, I look forward to getting back to it in September.
Events
Not an event as such, but the Housing Agency have released the call for applications for the Research Support Programme and their Educational Bursary. Full details here. On July 6th the ESRI will launch an important new piece of research looking at the interaction of tenure change and retirement. Last week I wrote about the recent cost rental seminar at the International Festival of Social Housing, you can now watch the full seminar here.
What I’m reading
Some new PRS legislation recently passed makes some relatively minor changes, including in relation to notice periods. Read the Bill here. A really interesting Dublin Inquirer piece here looking at a CATU project on the NATO rent strikes of the early 1970s, an interesting chapter in the history of Irish housing. A new report from the Centre for Housing Rights, Law and Policy at NUI Galway looks at Purpose Built Student Accommodation in comparative perspective. Focus Ireland published a really useful blog post looking at the disproportionate risk of homelessness for migrants in Ireland.