What Rising Interest Rates Mean for Your Portfolio
Potential interest rate hikes are capturing headlines and, as usual, prompting some handwringing among investors. While increases in interest rates can hurt real estate values and performance, they do not necessarily adversely impact the CRE asset class. Like most macro factors, the impact of interest rates is nuanced, situational, and tends to cut both ways.
This article looks at the general effects of interest rates on capital formation and real estate values, as well as specific factors that we believe investors may consider amid a rising interest rate environment — where to invest with rising interest rates.
Interest Rates – the Present Environment
Since the Great Recession, the Federal Reserve has kept benchmark interest rates near zero, looking to keep investment flowing throughout the economy and safeguarding what became the longest expansionary period in U.S. history. This was not a difficult choice, as inflation remained modest. The events of 2020 and 2021 abruptly changed the game: lockdowns and a robust fiscal response to the pandemic prompted a surge in consumption. Supply chain disruptions and labor shortages have amounted to too much demand chasing too little supply, putting upward pressure on prices. In 2021, full-year inflation in the U.S. stood at 7%. While the Fed signaled a measured response, statements in early 2022 portended three likely rate hikes within the calendar year to combat rising prices.
Note: in times of economic uncertainty, public market investments, such as stocks and ETFs, which are fairly liquid, may be subject to fluctuate more widely than private market investments and short-term government bond funds (i.e., U.S. Treasury bonds). The stock market, in particular, can swing up or down as individual investors react to speculation and adjust allocations accordingly.
Considerations for Real Estate Investors
The underlying fear with respect to interest rate risk and real estate: upward movement in benchmark interest rates will generally drive up cap rates and lower real property values, adversely impacting returns.
The argument goes that interest rate hikes increase the cost of borrowing – and hence cost of capital – and cool off real estate markets, as fewer bidders will compete when assets go to market for sale. Some investors also worry that higher interest rates have a dampening macroeconomic effect. Specifically,
- Curbing consumption: rising rates boost incentive to save – correspondingly lowering marginal propensity to spend and tempering consumer activity. Such a trend could adversely impact retail and hospitality CRE sectors most.
- Dis-incentivizing job-creating investments: higher interest rates increase the cost of borrowing, curtailing corporate expansion. In theory this could adversely impact office, industrial, and multifamily markets most.
As always, the reality tends to be more nuanced and varied. To understand how rising interest rates could impact CRE values, and where to consider investing with rising interest rates, we need to first examine the factors contributing to inflation, and hence to potential interest rate hikes.
The major forces contributing to inflation each impact capital markets in different ways. Let’s review:
Residential and multifamily market dynamics
Rental markets were already characterized by unaffordability before the pandemic. Homeownership rates were low, and demand ran ahead of supply in many markets, especially gateway metros with cultural and economic cache. The pandemic further accelerated adoption of remote work and in-migration to Tier II and Tier III metros. The result: both single-family values and rents soared in the back half of 2020 and 2021. With constrained new supply of single-family inventory, many would-be homebuyers were forced to keep renting, putting further upward pressure on rents.
Should interest rates increase, it’s possible that even greater numbers of would-be homebuyers will delay their home search, keeping upward pressure on multifamily rents. From this standpoint, the multifamily sector looks like it has strong potential for investors as interest rates rise.
Supply chain factors
The pandemic has disrupted supply chains and business inputs due to both labor stoppages and labor shortages. The former should abate over time, while the future of some labor markets is more uncertain. The “great resignation” may persist as employers of low-skilled workers have few carrots left to lure workers back to the job. Overall, the pandemic-induced supply chain issues have exposed the interconnectedness and fragility of global supply chains.
It’s uncertain how supply chain issues will resolve, when, and how asset classes will be impacted. The experience does serve as an example of how exogenous shocks can cause unanticipated and prolonged volatility. Supply chain issues have contributed to inflation, which in turn may usher in higher interest rates. Both factors — and even headlines regarding these factors — may roil public markets. (Indeed, January 2022 was the worst January for the S&P 500 since 2009). With interest rates on the rise, tangible assets may prove a wise bet. Specifically, multifamily and net-lease retail anchored by grocery (or other inelastic goods and services) may be a great place to invest with interest rates on the rise. If the U.S. economy slows due to rising interest rates, these physical spaces will remain essential. If market volatility becomes more pronounced due to supply chain issues, rising interest rates, or both, these sectors may prove relatively stable.
With extra time at home and extra disposable income (from an aggressive fiscal policy response to the pandemic), U.S. consumers bought even more stuff than usual in 2020 and 2021. This propped up the economy in general, and benefitted some real estate sectors and markets, like last-mile industrial and more affordable Tier II metros.
Even with inflation on the rise and fiscal stimulus tapering off, U.S. consumers generally still feel good about their own financial situation. In fact, optimism is growing.
With prices of goods rising far faster than services, this optimism may translate into increased demand for the experiences and services that the pandemic has deprived us of. The general upward trend in consumer optimism may translate to a rebound in demand for space in central business districts and cultural centers.
Private Real Estate Debt
Rising interest rates may increase the cost of borrowing for real estate developers and sponsors across the board, though this added cost can be priced into asset values if demand drivers hold. With a record number of CRE transactions expected in 2022, there will remain plenty of demand from potential borrowers.¹
If rising benchmark rates drive up rates that prevail among traditional lenders, private lenders — who can move more nimbly — may see additional opportunity. Private CRE debt investments may be another great option for investors to consider with interest rates on the rise.
Interest Rates and Real Estate: Economic Fundamentals Are Still King
When it comes to cap rates, the cost of capital is only one part of the equation. As Steve Kohn, President of Cushman & Wakefield Equity, Debt & Structured Finance puts it, “cap rates are more driven by one’s view of growth in the economy and growth in rents than interest rates alone.” In other words, the economic fundamentals in play at the macro level and at the market level matter more than marginal increases in the cost of capital. Annual multifamily rent growth was the highest on record in 2021, and most industry experts are forecasting robust growth in the sector over the next several years.²
While the office and hospitality sectors face questions going forward, several other emerging and niche CRE asset classes are rising to meet the moment, including assisted living facilities, student housing, car washes, and medical office buildings.
NOI Growth & Long Investment Horizons
The impact of rising cap rates is mitigated by the compounding effect of NOI over a multi-year investment term. Though investors are often motivated to de-risk by seeking shorter-hold investments, longer-term commercial investments with healthy interim cash flow may in fact reduce exposure to risk in a rising interest rate environment. With a solid average rent growth forecast for the next few years, we believe multifamily in particular may be a favorable asset class with interest rates on the rise.
The Bottom Line
The bottom line: interest rates rise in response to robust economic growth and, typically, to inflation as the economy heats up. While interest rate movements and inflation may introduce volatility to public markets, we think the factors that cause interest rates to rise tend to also favor real estate markets, writ large. A correction in the public markets is always possible; as of this writing, the price-earnings ratio in the U.S. is relatively high. If you are looking for where to invest with interest rates on the rise, you may want to consider private, illiquid commercial real estate.
¹REJournals, December 9, 2021: https://rejournals.com/a-big-year-for-cre-investment-in-2022-how-about-a-record-year/
²Multi-Housing News, January 26, 2022: https://www.multihousingnews.com/2021-rent-growth/
Disclosure: This document is for informational purposes only and is not an offer or solicitation to purchase or sell securities. Investing involves risks, including the potential for principal loss. There is no guarantee that the strategies and services will be successful or outperform other strategies and services. Certain assumptions may have been made in connection with the analysis presented herein, and changes to the assumptions may have a material impact on the analysis or results.
Past performance is no guarantee of future results. The investments discussed herein may be unsuitable for investors depending on their specific investment objectives and financial position. Investors should independently evaluate each investment discussed in the context of their own objectives, risk profile and circumstances.
All opinions expressed herein constitute the author’s judgement as of the date of this article and are subject to change without notice. Statements made are not facts, including statements regarding trends, market conditions and the experience or expertise of author are based on current expectations, estimates, opinions and/or beliefs. Such statements are not facts and involve known and unknown risks, uncertainties and other factors. Past events and trends do not predict or guarantee or indicate future events or results.
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