15.11.2022
Real estate stocks are signaling that a significant revaluation is coming, and the market faces three big challenges:
1) Political risk due to the war in Ukraine and, in particular, its impact on the euro and EU institutions.
2) Increasing housing rents as population increases due to immigration and delays in home buying by locals due to higher loan costs.
3) Higher interest rates and returns on alternative investments, causing commercial real estate investments to be overvalued.
Let’s focus on the revaluation of commercial real estate investments as this will be repeated many times throughout 2023 and beyond.
A real estate investor evaluates commercial, income-producing real estate on three dimensions, which together make up the level of capitalization of the income generated by the property. These parameters are the risk-free rate, the risk premium and the expected annual increase in the cost of capital. The risk-free rate is usually the interest rate paid on a 10-year government bond. The risk premium is the excess compensation received by an investor for taking on risk in a commercial real estate transaction, typically 2.0%. The growth in the cost of capital is usually the expected annual rate of increase in property prices over the next 3-5 years.
For example, if the 10-year government bond rate is 1.0%, the risk premium is 2.0%, and the cost of capital is expected to remain broadly unchanged, then the capitalization rate is 3.0%. A property that generates a rent of €12,000 per year will be valued by dividing €12,000 by 3.0%, which equals €400,000, i.e. someone buys a property for €400,000 and it will bring in 3 .0% of the invested amount. This was roughly the case in Cyprus until February 2022 (yield on 10-year government bonds was 0.6% in January 2022).
The 10-year Cypriot government bond rate is now 4.0%, the risk premium for real estate investing is now higher due to the increased global political risk and likely closer to 2.5%, and the expected growth in the cost of capital is negative, i.e. e. it is expected that in the medium term they will decrease (say, by only 1.0% per year). So 4.0% plus 2.5% minus -1.0% means the cap rate is now closer to 7.5%. The same property that brings in 12,000 euros per year is now valued at 160,000 euros, i.e. 60% less.
As the population of Cyprus increases due to immigration and commercial rents continue to adjust to the growing economy, let’s assume that property rents are expected to increase by 20% to €14,400. With this rent, using a capitalization rate of 7.5%, we would get a value of 192,000 euros, i.e. 52% reduction from the original €400,000.
Pavlos Loizou, CEO of WiRE FS
