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Rate hikes will affect domestic and small-scale investors in particular

financing rate hikes mortgages

For many years now, the cocktail of capital abundance and exceptionally low interest rates has sent the demand for investment property sky-high. Only last year, the Danish transaction volume hit a historical high of DKK 105 billion.

In many respects, 2022 is set to become another golden year for the property industry. However, the combination of climbing interest rates, historically high inflation levels and tighter financing terms may well trigger market jitters.

High interest rates do not impact financing opportunities on quite the same scale as they used to. In the aftermath of the financial crisis, the Danish FSA and, by extension, mortgage providers sharpened their focus on the actual operational aspect of real estate.

In other words, whereas mortgage providers used to be concerned mainly with the total amount of debt financing on a property, they are today much more focused on investment property KPIs, in particular EBITDA and equity capital.

In practice, this means that when you take out a mortgage on an investment property today, the property must produce a positive EBITDA based on standard financing, in this context defined as a fixed-rate loan with a repayment period of, say, 30 years for residential rental properties. This applies regardless of loan type, including adjustable rate or interest-only loans. If a property’s net income after interest, repayments and servicing fees turns negative, the amount of financing needs to be brought down until at least operational balance is restored.

Exactly in this respect, recent months’ strong rate hikes have probably impacted investor appetite for investment property, mainly because the increase in property returns has failed to keep pace with interest rates.



Given the current interest rate level, it means that when you acquire a residential rental property at a yield of, say, 3%, you can only achieve financing at an LTV of 48% (cf. Figure 2) as opposed to 63% in January (cf. Figure 2).

In other words, when purchasing a property with a price tag of DKK 100 million, you are today required to raise additional equity capital in the amount of DKK 15 million, compared to barely six months ago, merely on account of rate hikes.

It would make sense to consider taking out junior loans in terms of bank loans, mortgage deeds, etc., but the same positive EBITDA requirements apply as an overall evaluation is carried out in connection with the issue of mortgage loans, in principle ruling out the possibility of further mortgaging.

Transactions at such yield levels when it comes to fully developed properties are not unheard of in Copenhagen and Aarhus. Until recently, this was an issue that affected only residential rental property in Denmark’s two largest cities, but recent rate hikes have made it an issue in other large towns and cities, too, including Aalborg, Odense, Horsens and Vejle, and even in neighbouring satellite towns and cities, so it seems.

In fact, property investors have to aim for a yield as high as 5% or so on a residential rental property, for instance, in order to qualify for an LTV of 80%.

Rate hikes affecting mainly small-scale investors
What bearing has this on investor demand, then? The answer to this question is not unequivocal as it depends a lot on your point of view. The difference is most pronounced between domestic versus international investors as well as institutional investors such as pension funds.

A qualified guess is that international investors would tend to be the least affected. To understand how this ties together, we need to start in a slightly different place.

In recent years, Denmark has witnessed a sustained increase in the demand for commercial property from non-Danish investors. In fact, international investors accounted for 54% of total transaction volume in 2021. Investors are zooming in on Denmark as we offer competitive yields relative to European neighbouring countries. Economic and political stability are additional key socio-economic factors in this context.

Another attraction is the possibility of procuring long-term and high-leverage financing at low interest rates. However, Denmark’s fixed exchange rate policy against the euro is also an advantage because international investors are not required to hedge any exchange rate risk, which they are required to do in Sweden, for instance.

In combination with substantial liquidity placement requirements, this continues to make Danish investments attractive. International investors typically finance their acquisitions at LTVs of 50% or less, making them less susceptible to recent rate hikes.

Domestic investors, on the other hand, have in a historical context enjoyed the possibility of higher gearing on their investments than their international counterparts. As a result, they tend to be quicker to dismiss higher equity ratio requirements. International investors are expected to account for more than 50% of total transaction volume this year too, with the yield requirement therefore likely to remain largely unaffected – possibly seeing a slight upward correction of up to 0.25% in the mean return across all property types over the next 12 months.

Turnkey projects and forward funding losing ground
Many investors have in response to the demand for positive EBIDTA in connection with financing and climbing interest rates done right in focusing on the cash flows of their properties as well as the return on equity capital, which has deteriorated in recent months, all other things being equal.
However, there is another important factor for investors to consider, too.

In recent years, turnkey acquisitions, often combined with forward funding, have become a more widespread phenomenon. In the event of forward funding, the buyer puts up the required equity capital to fund the seller’s construction of a property. This model has certain advantages as it may to some extent limit or optimise sell-side capital requirements, especially if the seller is involved in multiple concurrent projects.

Forward funding has therefore enabled also developers, who have not had sufficient capital, to carry out development schemes together with a buyer. By the same token, this has given buyers the opportunity to enter the process at an earlier stage, at the risk this invariably entails, but with the upside of a lower purchase price per square metre.

Evidently, the buyer assumes a construction risk together with the seller, but there is another risk that only few investors may realise, that is, project end-financing. As it is, Danish mortgage credit legislation prescribes that notice of building completion must be given in connection with the end loan. Key to achieving the completion certificate is that the budgeted rent and the projected yield requirement prove feasible.

A simple example to this effect is a property that has traded at DKK 100 million, reflecting a yield of 3.5%, and is scheduled for completion in two years’ time.

Aiming at an LTV of 80%, the buyer is required to raise DKK 20 million. At the time of notification of completion and end-financing of the project, the yield requirement may well have risen by 1 ppt to 4.5%.

The purchase sum remains DKK 100 million, but the mortgage provider now estimates the value of the development at DKK 78 million, with 80% financing now amounting to only DKK 62 million as a result.

The equity capital requirement has therefore grown from DKK 20 million to DKK 38 million, i.e. almost doubling, which amount the investor is required to raise on his own, all other things being equal.

Exactly this risk cannot be hedged, with financing therefore bound to entail some risk. This is hardly a new phenomenon but has not been an issue of relevance in a market upturn.

The risk is likely to affect investor demand to the effect that the market will see a shift in favour of properties scheduled for imminent completion, that is, within 6-12 months, or fully developed and fully operational properties. In addition, property owners increasingly face banking sector demands of equity capital being sourced directly form the owner of the project as opposed to the future buyer when taking out building loans. In consequence, the coming years will in all probability see weaker appetite for turnkey properties with 2-4 years to completion.

Rent adjustments may counter the effects of inflation
High inflation has already started to take its toll in terms of bankruptcies in the developer community. Many developers have operated according to fixed-price and fixed-time contracts, meaning that developers have incurred part of the losses due to price hikes before being able to pass on the bill to the property owner.

Anecdotal evidence has is that the small print in contracts dealing with price hikes is getting more attention. Moreover, the owner and the developer may have conflicting interests. One of the short-term effects could be an increasing tendency to call a halt to development schemes in the early stages, which is expected to have an adverse effect on the transaction volume.

However, it is not altogether bad news that interest rates are on the rise. Properties benefitting from a central location and secure cash flows may well become more coveted as instruments of inflation hedging. Both residential rental properties, offices and industrial/logistics properties, but also retail, may be gaining ground post-COVID-19.

In many instances, inflationary increases could well open up for rent adjustments, to some extent countering the effects of climbing interest rates along with the anticipated yield decompression. In this context it is important to bear in mind that rent increases may prompt higher churn rates, triggering fluctuations in the property’s liquidity due to vacancies and re-letting expenses.


How property investors fare, however, depends on the specific location and type of their property assets.

In Copenhagen, for instance, the supply of residential space has for years been greatly outstripped by demand, with the shortage of space hitting an unprecedented high of more than one million square metres in 2016, driving up housing prices and residential rent levels alike. The increases have caused a shift in demand from the city to Greater Copenhagen locations, suggesting a fine breaking point for how much the rent may be raised before tenants flock to the suburbs. With housing shortage still prevalent in Copenhagen, there should be a basis for further rent increases.

In Denmark’s second-largest city, Aarhus, substantial housing shortage has given way to some kind of supply and demand equilibrium. This is reflected in the general trend in market rents, which have been largely stable for the past three or four years.

The situation has changed the landscape for investors, who are now increasingly required to offer the right dwellings with the right layout and high specifications, at the right prices and in the right locations. The stronger competition for tenants may therefore render it difficult to raise rent levels indiscriminately.

Broadly speaking, however, population forecasts continue to show that major towns and cities are growing. In tandem with a possible slowdown in newbuilding, this may quickly change the situation and trends.

So where are we headed?
As we all know, it is difficult to make predictions, in particular about the future, but according to a blurry vision in the crystal ball, the next 6-12 months will see a slowdown in general transaction activity.

The market is fragmented, with domestic and international investors as well as pension funds faced with different investment fundamentals. As a result, the yield level is not likely to track the movements that interest rates could be argued to warrant in the short term. 

In the short run, rate hikes will mainly affect domestic investors due to tighter equity ratio requirements. Newbuilding will be halted due to price hikes on construction materials and a weaker appetite for turnkey projects, awaiting more fortuitous circumstances.

Despite the challenges looming ahead, however, we see many favourable trends too. The market continues to be characterised by ample liquidity and capital, which will ensure fair transaction activity in 2022, although hardly outperforming 2021.

The appetite will grow stronger for operational core properties, with take-over following on the heels of acquisition. Real estate remains an interesting asset as a means of allocating capital to a portfolio, to some extent providing a hedge against inflation in terms of rent adjustments.

Longer term, an increasing residential undersupply, due to a slowdown in newbuilding, could further accelerate this trend.

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