Last week I said the ECB would hike rates as aggressively as needed to kill off inflation. 

It will be the first ECB rate hiking cycle since the mid-2000s. And if they go the whole hog and induce a recession, it’ll be the first time a major central bank has done that since 1981. 

What I’m getting at is that, for the markets, this isn’t just another quarter. It’s an important moment. 

Since at least the mid-1990s, central banks have been a safety net. At the first sign of trouble, they stepped in and stimulated the economy. This happened four times: in the 2001 recession, the 2008 Global Financial Crisis, the 2011 European sovereign debt crisis and the 2020 pandemic.

Now, for the first time in 30 years, markets are on their own. The Ukraine invasion has caused havoc. But there’s not much central banks can do about it. 

There’s nothing central banks can do because inflation is intolerably high. Any stimulus would make matters worse. So they have no choice but to raise rates, into a slowing economy and falling markets. 

The big unanswered question at the moment is how much will rates have to go up in order to kill off inflation. If we’re lucky, a gentle tap on the brakes will be sufficient. If we’re not, there might be a recession. The latest news from the ECB is that it’s thinking of raising rates even faster than it had previously told markets to expect — by half a percentage point in July, rather than a quarter percentage point. 

But whatever about the specific mix, we’re looking at some combination of higher interest rates and slower growth. A new regime.

This will shake out in all sorts of ways. But one thing that’s sure to be affected is property development. 

New model

Over the last 13 years or so, Ireland has come up with a whole new way of funding property development.

In the old model, small builders would borrow some money directly from a bank, build a few houses, sell them, repay the loans, borrow some more, and build again. Rinse and repeat. In 2007 we were pumping out 80,000 homes per year in this way.

After the global financial crisis, banks got off the pitch. Tough new rules discouraged them from lending to risky industries like property development.

Into the gap stepped non-bank lenders. They came from New York and London. Many were very big. They were often attached to the private equity funds that were buying up big chunks of NAMA assets at the time.

Non-bank lenders’ funding schemes are complex. They usually involve a borrower, a lender, and a warehouse lender. 

The non-bank lender might source money from global private equity funds. And then to juice returns, the lender will borrow money from a warehouse lender at a low-interest rate. The warehouse lender goes at the top of the queue in the event of a problem with the loan. The non-bank lender goes further back in the queue but gets a higher return. These are the people funding the Irish property industry in 2022. 

Property investors, and property lenders, are interested in the space between yields and the risk-free rate. Yield is the income from a property as a percentage of its cost. The risk-free rate is basically the interest rate on a government bond.

The bigger the spread between yields and the risk-free rate, the more fertile the territory for property developers. It means, for people who need income, property deals are one of the only games in town.

The private rental sector — big apartment blocks, basically — has had a yield of about 3.8 per cent. Meanwhile, for the last eight years or so, the risk-free rate has been roughly zero. Leaving a spread of 380 basis points between the two.

But now we’re in a new regime. Irish 10-year government debt now yields two per cent, so the spread between the risk-free rate and a PRS property deal has shrunk from 380 basis points to 180 basis points.

A PRS property deal is riskier than a loan to the Irish government. Investors are being asked to take the same amount of risk — if not more, given the slowing macroeconomy — in return for a payoff that has fallen a lot in relative terms.

On paper, the worry would be that these American funders and warehouse lenders decide that there are less risky ways to make money than navigating the Irish PRS market. And they pull the plug on marginal deals. The construction of new homes slows down, and affordability gets worse.

International lenders fund more than just PRS. A Deloitte Survey (admittedly from 2017) showed that 34 per cent of alternative lending went to the property, 17 per cent went to hospitality, 11 per cent went to healthcare, 9 per cent went to energy, and 29 per cent went to other areas. 

This situation — rising rates in a slowing economy — is a rare one. It’s been decades. So it’s hard to say how it’ll play out. Colin Richardson of CBRE makes the case for optimism: 

“The investment case for Irish real estate across sectors including PRS, offices and industrial is highly robust, and notably is relatively attractive versus other major European cities. Wider yields (vs. other major European cities), favourable supply/demand dynamics, a strong tenant profile, and hugely attractive economic and employment demographics are all factors that act as a positive catalyst for continued investment into the Irish market. Indeed investment volumes in the Irish market have been strong in the first half of the year (reaching over €3bn) and we expect that the second half of the year will see continued momentum in large scale transactions across prime Irish real estate, despite global macroeconomic headwinds”.  

But looking at that collapsing spread between the risk-free rate and yields on property projects; and looking at Ireland’s new system for funding property development, you would worry.