Even if you are not a finance person, it would be hard to miss the news about interest rates rising, whether it’s from pundits on news broadcasts to advertisements for home loans – it seems to be one of the hottest talking points of the day. For real estate investors, rising rates beg the question: “What should I expect from my investments?
To answer this question, one must first understand why interest rates rise. The Federal Reserve has a dual mandate of encouraging growth and limiting inflation. When the Fed lowers rates, it makes access to capital cheaper to spur growth, and as this growth gains traction, the Fed raises rates to keep inflation in check. Herein lies the problem with assessing the effects of interest rates on real estate values.
Overall, commercial real estate values are resilient in a rising rate environment because ostensibly, the economy is growing, which creates demand for commercial real estate. As demand increases, prices rise. In addition, this means inflation is on the rise which also means the replacement cost of the asset rises as land, materials, and labor are also rising. Furthermore, commercial real estate also has a built-in hedge against inflation, as it often has rent escalations tied to inflation, which ideally allows the asset to maintain its cash flow value spread over the risk-free return.
Where rising interest rates hurt commercial real estate investors, is in the refinancing of assets. If aggressive leverage is currently in place and the property is already at market rents, then in the short term the value will go down but the real property, less the cash flow, should technically still be rising.
Even though long-term trends show a 70% correlation between cap rates and interest rates, it is important to differentiate between causation and correlation. There does not seem to be any direct connection between the two – the primary driver of cap rate compression is based on real estate fundamentals such as vacancy rates, lease rates, geographic market conditions, etc… All else being equal, it would appear, having low interest rates could pose a more likely problem as it could enable too much new supply which would then lower demand and lease rates.
From my perspective, a rising interest rate environment could have a short term detrimental effects on values if the asset isn’t positioned correctly, but overall when rates are rising, the underlying factors causing the rising rates are accretive to asset values.
This post was written by Danny Mulcahy, the Director of Equity at Northstar Commercial Partners. If you’d like to reach out to Danny, you may contact him at firstname.lastname@example.org.