Guest article by Dr. Robert Weinert, Wüest Partner
Over the past 1.5 years, the changing economic environment has left its mark on the Swiss real estate market. The price momentum for residential property slowed and indirect real estate investments experienced price corrections, some of them considerable. At the same time, investment behavior in direct investments changed, which led to declining transaction volumes and a lower willingness to pay. These developments show the expected market reaction to the interest rate turnaround. In addition to the existing challenges, the future should also offer stability and potential.
Residential property: Stable development with regional differences
Prices for condominiums continue to rise in Switzerland. In the second quarter of 2023, they increased by 3.4% compared to the same quarter of the previous year - even though prices are already at a very high level and financing costs for residential property have more than doubled due to rising mortgage interest rates. This surprising development can be explained by several factors: the entry of new and high-quality apartments onto the market, the influence of second homes, whose prices have risen particularly sharply due to high demand, and the lack of alternatives in the rental segment.
The situation is somewhat different for single-family homes. From a national perspective, prices are still rising (+1.2% compared to the same quarter of the previous year). However, demand has fallen sharply (21% fewer search subscriptions in June 2023 compared to June 2022) and supply has increased in parallel. Around a third of the country (31 out of 106 MS regions) is currently experiencing falling prices.
The residential property segment is expected to remain relatively stable in the medium term. Despite the recent increase, supply remains limited. The continuing downward trend in new construction activity and the financial stability of Swiss households, who are not under pressure to sell their properties as a result of rising interest rates, continue to support prices. Nevertheless, after years of continuous price growth, regional price adjustments are likely to occur in isolated cases.
Indirect real estate investments: mixed sentiment
As at the end of August 2023, Swiss real estate stock corporations recorded an average total return of 4.5% (measured by the WUPIX-A). Although this did not fully compensate for the previous year's decline, the average annual performance over the last 10 years was 6.6%. This year's performance was characterized by relatively low volatility in daily returns.
Real estate funds recorded an extremely poor performance in 2022 (average performance according to WUPIX-F: -15.5%). And the current year also shows a negative trend up to the end of August 2023 at -2.3%. The volatility of daily prices remains above the long-term average and clearly exceeds the values during the subprime crisis from 2007 to 2008.
There are various reasons for the negative performance again this year, despite below-average premiums (premiums over the estimated net asset value) and favorable cash flow prospects: Firstly, some pension funds and insurance companies are holding back due to the still high proportion of real estate in their portfolios. Secondly, real estate funds are particularly exposed to interest rate rises due to their pronounced interest rate sensitivity. And thirdly, ongoing uncertainties are causing instability in the real estate fund market. A key concern is the fear of extensive redemption requests from investors, especially if the net asset value (NAV) of a fund exceeds the market price.
Although there are numerous challenges, there are increasing signs that real estate funds could develop positively in the future. However, the exact timing of this positive turnaround remains uncertain.
Direct real estate investments: significantly less trading activity in 2023
In 2022, at the beginning of the interest rate turnaround, the transaction volume experienced an unexpectedly strong increase. This surge occurred when some investors adjusted their portfolios and sold properties that were not in line with their strategy. Trading activity declined noticeably in 2023, meaning that the transaction volume is now well below the average of the past ten years.
In the context of the interest rate turnaround, prices for residential investment properties fell. Nevertheless, the decline was moderate in relation to the average annual price increases of the last ten years. Since the price peak in the 4th quarter of 2022, prices for traded residential properties have fallen by 4.4% (on a constant quality basis). Commercial properties recorded a sharper decline in prices: since the peak in Q2 2022, prices have fallen by 8.0%.
In the second half of 2022 and in 2023, average net initial yields on Swiss investment property transactions increased. For residential properties, there was an increase of 30 basis points during this period compared to 2021. However, part of this increase can be attributed to the lower quality of the properties traded. Commercial properties, particularly those with office and retail space, recorded an increase of 60 basis points.
It can be expected that initial yields will tend to rise in the coming year. The higher interest rates tend to have a negative impact on investors' willingness to pay. Although no drastic interest rate increases are expected in the coming months, which would suggest constant initial yields, the real estate market generally reacts to interest rate changes with a time lag. As a result, the interest rate rises that have already taken place have not yet been fully priced in.
In addition, rents are currently trending upwards, which also points to rising initial yields. This is due on the one hand to the housing shortage and on the other to the ability to pass on inflation-related additional costs to tenants. This picture is supplemented by the mortgage reference interest rate: this is likely to rise again in December 2023. Additional rent increases are therefore to be expected in the course of 2024. A further rise in the reference interest rate is also on the horizon for 2025.
After a decade in which there were hardly any attractive investment alternatives to the real estate market, the interest rate turnaround has changed the situation. However, this new starting position does not mean that the real estate market itself is no longer an investment alternative. The very stable development of direct investments, even during turbulent times, and the promising earnings prospects on the user market should help to ensure that real estate investments remain attractive in the coming years.