Property market slowdown as interest rates rise?

Arvid Lindqvist, Head of Research at Catella Corporate Finance, and Martin Nilsson, who manages funds including Catella's Hedgefond and Småbolagsfond, took part in Catella's December podcast.

The current position is that interest rates have been extremely low for a number of years. How will the property market handle this? Both Catella experts agree it may be difficult.

"We have conducted a supply and demand analysis on the residential side. There has been a very sharp increase in supply; in Sweden as a whole more than a doubling in the rate of new production over the next two years. And in Stockholm a threefold increase from an annual rate of around 8,500 homes to up to 20-25,000. Looking at demand, this is around 16,000 to 19,000 homes per year, so for the current population growth this is too much housing," says Arvid Lindqvist.

There is often talk of pent-up demand in the housing sector, especially in the big cities. This has resulted in a market that is priced on a shortage and on high new-build prises. According to Arvid Lindqvist, we have been building too little for 20 years, and in the 1990s production was far below population growth. The problem in the housing sector is the lack of people standing on the side-lines with money in hand.

"Now that the supply is coming through, it is likely to affect pricing. We may not get sharp price declines, but the rate of new production will decrease. Construction prices rise when a capacity ceiling is reached. Plans by municipalities have difficulty in keeping up, and we also see infrastructure as a bottleneck," says Arvid Lindqvist.

His theory is that when it becomes more difficult to rent out or to sell condominiums, the rate of new production will decrease. The number of housing developers, especially in the Stockholm area, has increased sharply. There may be consolidation ahead.

"Those with development rights in good locations, and who know about property and have their own construction resources and a strong financial position will do well. It will be more difficult for those with development rights in less attractive locations and with weaker finances," continues Arvid Lindqvist.

He says that the fact there is new production coming through at the moment is due to low interest rates, record-high housing prices due to scarcity, and enormous political pressure to build more.

The structural change in the market for rental housing over the past five years has meant the entry of a number of listed providers that are good at managing. Tenanted and condominium properties are linked, according to Arvid Lindqvist, because politicians demand the development of both options. Now there are clear takers, and the market for rental housing is now very similar to the market for commercial housing, unlike before.

The question is what will happen with the market going forward.

"Last summer we saw interest rates bottom out. The policies being driven by central banks are no longer tenable and are having no positive effects. Donald Trump's victory in the US presidential election has only escalated the process. The US is booming, and it is difficult to find staff in some sectors, and we all know what that leads to: higher wages, which drive inflation," says Arvid Lindqvist.

One concern with Donald Trump's proposals is that they involve fiscal stimulus at a time when the economy is at full capacity. This is almost guaranteed to lead to inflation and higher interest rates.

Population growth in Stockholm is currently 35-40,000 annually, and construction is shifting from 8,500 homes to up to 20-25,000 per year. The need is there - but not the purchasing power.

"The problem is that demand and purchasing power cannot always be matched up. The population growth that is occurring is from a birth surplus and immigration from abroad. Perhaps only one tenth are moving in from other parts of Sweden," says Arvid Lindqvist.

Sweden's many single-occupancy households are a function of the regulated rental market. This creates what Arvid Lindqvist calls "artificial demand" for new production. A recent analysis by Catella's corporate finance department investigates what would happen if mobility were to improve. This would reduce the demand for new construction, and much of the existing shortage could be resolved withing the existing stock. At this point, says Arvid Lindqvist, demand would fall to 10-12,000 homes per year. At the moment they are trying to solve the current problem with new construction.

"The competition that established construction companies have experienced from smaller builders has existed for a number of years. The established providers have 'moved out of town', so to say. They have not gained access to the attractive areas because they have not been willing to pay the prices. The construction industry is a low-margin business. If they have problems with their projects or cost inflation, margins can be eroded quite quickly," says Martin Nilsson.

Much higher rents can be set for new-builds. But the Swedish Union of Tenants (Hyresgästföreningen) is fighting back, not least in Stockholm.

"At the same time they are very positive toward the construction being done. And you can set very high rents for new builds. These rents are necessary to make rental housing economic. The prices of condominiums are driving up building rights to very high levels," says Arvid Lindqvist.

Rents for newly built homes are now often over SEK 2,000 per square meter per year, and are even higher in newly built Djurgårdsstaden – toward SEK 2,500 per square meter.
"This creates tensions when you have an existing stock with rents half the level per square metre. It can be quite difficult to rent out new builds, and they may perhaps no longer rent themselves out. In the older stock the level is perhaps SEK 1,100-1,200 per square metre, and in the new stock SEK 2,000," says Arvid Lindqvist.

The opportunity for property owners to improve their yields is limited. In addition to cost efficiency, they have to renovate in order to raise rents.

"Half of all the growth is happening in Stockholm. The population growth we are experiencing is largely immigration from abroad, which generally has fairly low payment capacity. This means you have to match expensive newly built housing with a population that has weak paying power," says Arvid Lindqvist, and points out that the correlation between property prices and global GDP is strong - stronger than the correlation with interest rates.

"Swedish GDP growth is timed about three quarters ahead of yields in the property market, and if we look at short-term interest rates it is around seven quarters ahead. What we are seeing now is a slowdown in GDP growth. In the third quarter we were at an annual rate of 2.8 percent, and we have had three consecutive quarters of around a half percent quarterly growth. The economy is at its capacity limit and is slowing going forward. This is happening at the same time as we are getting higher interest rates, because we are in an imbalance," continues Arvid Lindqvist.

Martin Nilsson points to a recent meeting with representatives of the four major banks, where he enquired about their lending and exposure. All of them said largely the same thing: they have tightened their belts when it comes to commercial real estate.

"However, they are not seeing any bubble for households. On the other hand they are worried about interest rates going up. But more in terms of other consumption: people will still pay on their loans, but there will be a negative secondary effect," says Martin Nilsson.

According to Arvid Lindqvist, it is still housing that will do well going forward, while commercial property will be able to do well in the most attractive locations. He still expects a contraction for housing prices – but a controlled contraction.

"We expect a 10-15 percent price drop within 12-18 months. The turning point right now is in the fourth quarter. The availability of credit declined sharply in the fourth quarter of 2015, and we know there's a lag of around one year between credit market sentiment and the property market. Volumes are also peaking right now," says Arvid Lindqvist.

Martin Nilsson is downbeat about the property market in general.

"We have shorted the Swedish property market. The largest short position is Balder. This case came from a presentation by Catella's corporate finance department, so it is pleasing to have this expertise in-house," he says.

According to Martin Nilsson, the problem is a combination of high debt levels and rising interest rates. The sector has been "hot", which has now generated something of an optimal position to make money on the downside. In addition to Balder, Martin Nilsson's hedge funds have shorted Fabege and Kungsleden, which has generated good returns in just a short time.

Of course, if interest rates were to go down again the situation would be exactly the reverse. But, to return to the eternal question, what will things look like in twelve months?

"Interest rates will be higher. And share prices lower. Otherwise we are looking mostly at cash flows. Balder does not pay a good dividend either," says Martin Nilsson.

And what will happen to house prices? Down a bit, perhaps.

"I bought my first apartment in Hammarby Sjöstad for SEK 19,000 per square metre in 2002, and a Toyota was included, plus no service charges for a year. The problem then was getting a loan," says Martin Nilsson.

Arvid Lindqvist is keeping his fingers crossed for a calm trend.

"Housing prices are the key. We hope for, and expect, a stabilisation rather than a severe decline - because then we would have a recession."

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