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How Will Rising Interest Rates Affect The Real Estate Market?

25 Mar 2016

When will the Federal Reserve raise interest rates? This is the question that hangs over the commercial real estate industry today. Since 2009, the Federal Reserve’s Quantitative Easing (QE) program has brought about an unprecedented low-interest rate environment, driving a period of strong returns in the commercial real estate market. With the end of the QE era in sight, commercial real estate investors now must consider how an interest-rate increase will impact their portfolio values.
Investors are taught that real estate returns should be higher than U.S. Treasury returns to compensate for the risks associated with real property. A key metric in real estate valuation is the capitalization rate, or cap rate, which typically trades at a premium to U.S. Treasury “risk-free” rate. The cap rate is similar to a bond yield, or the inverse of a price-earnings multiple in equities, in that it compares the net operating income of the property to its overall value. Many investors assume that when the Fed raises interest rates and the risk-free rate increases, then real estate cap rates will increase and values will go down.

However, in the real world, it is not this simple. Interest rates are certainly central to real estate valuations, but there have been several instances over the last thirty years when there was not a correlation between rising interest rates and rising cap rates. Many other factors – beyond interest rates – must be considered when evaluating the condition of the commercial real estate market, including the availability of credit, tenant demand, and inflation.
Let’s look at each of these drivers of real estate values.
Regardless of interest rates, the availability of credit has an enormous impact on real estate values. For example, according to a 2014 Morgan Stanley Research report, from October 1998 to May 2000, U.S. Treasury rates increased 191 basis points while the stock of U.S. commercial real estate mortgages rose by more than $450 billion. As a result, cap rates fell by 32 basis points over the same period and by 5 basis points, one-year forward. In contrast, during the early 1990s (December 1989 to October 1990), U.S. Treasury rates increased 88 basis points, while lending stock scaled back by over $50 billion. In this instance, cap rates increased by 68 basis points over the same period and 150 basis points, one-year forward.

Today, the commercial mortgage-backed securities market is thriving. Lenders are using conservative underwriting standards, but still making loans. When rates go up in the near future, the lending market will most likely remain healthy.
The leasing market is also in excellent condition. Several experienced brokers in the Southern California industrial real estate market have stated that today’s market is the tightest they have experienced in their careers. Lease rates are going up and vacancy rates are at historical lows. Increased rents result in higher net operating income. The more net operating income generated by a property, the greater the likelihood that the property will also appreciate in value, even if interest rates increase.

The final major variable is inflation. Conventional wisdom is that inflation results in higher rents and that real estate serves as a hedge against inflation. Increases in inflation are frequently offset by increases in rental income.
Investors who assume that the value of their portfolios will decrease in a rising interest rate environment are failing to look at the entire picture. Over the past thirty years, the connection between cap rates and interest rates has not been consistent. Other factors such as the lending market and tenant demand have a major impact. In preparing for the Fed to raise interest rates, smart investors will assess the real estate market by looking at all of the variables mentioned above.
This blog is produced as a resource for real estate investors by the senior management of Hager Pacific, which includes David J. Hager, Adam Milstein, Robert Neal, and Jason Schirn.

About the Author: Adam Milstein
Adam Milstein is a managing partner with Hager Pacific Properties, overseeing the firm’s financing, disposition and property management.