What are likely effects of ECB rate hike on mortgage and property lending?

The European Central Bank seemed to have caught a lot of observers by surprise by hiking its base interest rate from zero to 0.5%, its first interest rate rise in more than ten years.

Mortgage and real estate finance, which operate on a different set of rules, have tripled in Germany over the past year, from under 1% to now 3% or more, for ten-year fixed term loans. While there is a correlation between the two interest rates, mortgage rates are more closely coupled with the yields on ten-year government bonds.

Of more importance to real estate investors is how the market reacts to the ECB rate rise. Investors could take the view that the hefty rate hike could cause further problems for countries like Italy and Spain, and further flee into German Bunds. Pushing up the price of bonds would compress their yields, and could even act as a dampener on mortgage rates.

Claudia Reich Floyd, who heads up the German office of Toronto-headquartered asset manager Hazelview Investments which invests in listed real estate companies globally, believes that, for REITS at least, the rate hike will have little effect on institutional investors's decisions. “REITs are typically hit hard when central banks begin talks of raising interest rates. This is due to investors views on how the higher interest rates will impact a REIT’s cost of capital. So, a lot of investors’ concern in this regard is already priced into the share price of listed REITs.”

She counters the popular perception that REITs and listed property companies don't perform well in a rising interest rate environment. “It is important to note that a tightening monetary policy is typically coupled with strong economic and job growth – fundamentals that lead to demand outstripping supply and driving rental growth in real estate.”

Hazelview's own research shows that while REITS might actually perform poorly at the beginning of a rising-rate cycle, this turns quickly, as the market anticipates and immediately prices in the risks of higher policy rates. “In periods where rate hike talks turn to rate hike actions, REITs have historically performed very well”, says Reich Floyd, pointing to the North American experience: “In the US, for example, where interest rates have already been rising this year, the last four rate-hiking cycles since 1994 resulted in a 12% average return for REITs on an absolute basis, outperforming the equity markets by almost 300 basis points.”

Markus Kreuter, managing director at Zinsbaustein.de, a German platform for curated digital real estate investments, sees the ECB's move as the definitive end for negative interest rates on call deposits at banks and savings banks. Is this, he asks on a LinkedIn post, like the proverbial mouse given birth to by a mountain range in the poem by Horace ("Parturient montes, nascetur ridiculus mus"), or is there something much bigger behind the interest rate hike?

"For investors, the ECB decision is likely to have an immediate impact. It can be assumed that banks and savings banks will abolish negative interest rates for call deposits across the board, putting an end to the noticeable loss in value experienced by investors with the deduction of penalty interest.

"What remains is the invisible loss in value of the cash reserves set aside. There is a high probability that the current record-high inflation will settle down again at a reduced level after one-off effects have been reduced. To counter the inflation-related loss on the value of their deposits, investors should ensure that their funds earn interest at a rate of at least 4.5 per cent per annum. This is the only way to ensure value preservation after the short-term dislocations have subsided.

"This is all true if the markets behave according to the textbook. But we know - and certainly since February of this year - that fundamental market mechanisms can be overridden. The German and European economic model is facing high and lasting challenges that require new and creative approaches. The decisions in the ECB's Frankfurt tower today may have far-reaching consequences.

Meanwhile, for private investors in German real estate, mainly residential housing for their own needs, the last few months have seen a turnaround in enthusiasm for buying private property. What effect will the ECB rate rise have on their dampened interest given the near-tripling of mortgage rates over the past six months?

Michael Neumann, CEO of mortgage broker Dr. Klein, commented on the hefty rate rise by the ECB, after Christine Lagarde had confirmed as recently as end-June that 0.25% was the likely increase. "With this higher rise the ECB is showing courage. Ms. Lagarde is demonstrating her determination to tackle inflation, and that she's prepared to take risks to do so." However, Neumann doubts it will have much effect on inflation, given that its causes in Europe are less due to an overheating economy, as in the USA, but rather in high energy prices.

"The market has already priced in a key interest rate of 1% by the end of the year, which is why building interest rates have not risen any further recently. On the contrary: after a temporary peak in June of almost 3.2%, the best interest rate fell in July to currently 2.74% (as of 20.07.2022). The key question is: Will the ECB go significantly beyond this 1% in the next 12 months? In that case, higher building interest rates would be possible again.

Neumann is not expecting a further significant rise in rates this year. "Despite all the need to take bold action against inflation: Christine Lagarde does not have enough leeway to raise interest rates hugely. Therefore, I expect a sideways movement of building interest rates. At least on balance - because we will see large swings in both directions in the coming weeks and months." Given the factors the ECB has to weigh up on a daily basis - supply bottlenecks for raw material and energy, Europe's economic outlook, the war in Ukraine, the government crisis in Italy, interest rate movements by the Fed, - all of which impact on bond yields and hence interest rates on mortgage finance, banks are adjusting their rates up and down almost daily. Neumann is recommending checking the best offers available almost on a daily basis.

The rise in mortgage interest rates, coupled with property prices which haven't yet fallen significantly, is bad news for buyers, faced with a combination of the worst of both worlds. Dr. Klein, which is part of Hypoport, whose Europace platform handles about 10% of German mortgages, is seeing demand for housing finance slackening off considerably.

"After the abrupt rise in interest rates in the first half of the year, many potential buyers are in waiting mode. Some are postponing their plans and hoping for slightly falling property prices, others first have to get used to the 'new' interest rate level." He sees the biggest slump in building projects: In view of the supply bottlenecks, the shortage of materials and the lack of skilled workers, it is currently almost impossible to calculate prices and get reliable offers, he says. Large numbers of new construction projects have been put on hold.

Less demand also means less competition on the property market. Marketing times are currently increasing and properties that used to be sold immediately and without a diversion via relevant portals are now being officially advertised again, says Neumann: "In many locations, interested parties can negotiate prices again - and they should try to do so. Sellers are no longer in the driver's seat."