Increased interest rate level threatens earnings opportunities of property developers

Sensitivity analysis quantifies risks

In the area of residential real estate, the rise in interest rates affects key buyer groups differently:

Owner-occupiers reach limits

Owner-occupiers regularly finance the purchase of their property with a loan, for which payment installments are then due. In doing so, customers often reach the limits of their financial capacity, which is based on their income. If the limit and thus the payment installment remain unchanged, a lower loan amount can be serviced and a correspondingly lower price paid if interest rates rise.

For investors, yields change

For rental investors, the return on equity employed is a key target figure. At least for the period of the fixed interest rate, the interest rate of the debt capital share – which is often high due to leverage considerations – represents a significant cost component.

In times of rising interest rates, this is compounded by the fact that alternative investments, with which real estate competes in some cases, are becoming more attractive and thus the return requirement is actually increasing. When interest rates rise, they can service fewer loans and accordingly only pay lower prices to developers, for example.

For developers as sellers, changes in interest rates mainly affect the revenue side

HANSE Consulting has modeled and quantified the effects of interest rate increases on the revenue situation for property developers with a market focus on the construction of multi-family houses with sales to investors in a sensitivity analysis.

The model calculation was based on a project volume of EUR 210 million to be realized in the period 2023-2025.

Due to the long lead times in the property development business, planning and cost calculations that take appropriate account of construction cost increases have already been completed by the end of 2021.

However, the increase in interest rates in 2022 and a further possible increase in 2023 have not yet been included in the planning of achievable sales prices. For the initial situation, an industry-standard profit margin of 16.9% has been assumed. (Source: IBIS World Sector Report Property Developers March 2023)

For the initial situation, a construction interest rate of 1.7% (100% debt financing of the purchase price by the buyers/investors) and a return on equity of 3.6% expected by the investors have been assumed. Based on this, we have modeled how rising construction interest rates can reduce the achievable sales prices:

• Investors try to compensate rising financing costs with lower purchase prices for the properties.
• Rising returns from other investment opportunities further reduce the prices investors accept.

Our model calculation models the adjustment of sales prices to the varying level of construction interest rates and the varying return investors demand.

Conclusion of the sensitivity analysis

When applied to a developer’s specific project portfolio, this sensitivity analysis can provide important insights into the risks (and opportunities) of earnings development. However, this sensitivity analysis excludes other factors that could be considered in a more extensive forecast of the earnings opportunities of a developer’s project portfolio:

• More extensive potential rent increases resulting from inflation.
• A higher expected residual value of the property at the end of the investment period.

How sensitive is the earnings situation of your company to rising interest rates,
which effects would have to be considered in a qualified sensitivity analysis?
Please arrange a non-binding appointment with one of our experts.
Dr. Armin Bratz - Thomas H. Barth

---

---