Real Estate Investing in a Rising-Interest Rate Environment

While real estate capital markets continue to exhibit strong transaction volume across most markets, there has been some chatter in recent weeks regarding rising interest rates, and potential correlated increases in cap rates adversely impacting returns on real estate investment. The underlying fear with respect to interest rates and real estate: upward movement in benchmark interest rates will drive up cap rates and lower real property values, adversely impacting returns.  

The logic at work here is simple (overly so, it turns out): 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, rising rates boost incentive to save – correspondingly lowering marginal propensity to spend and tempering consumer activity – and dis-incentivizing job-creating investments. This presumed outcome would lower demand for commercial real estate assets, all else being equal, adversely impacting property values.

The problems with this thesis are as follows:

Interest Rates Rise in Response to Robust Macroeconomic Factors

The Fed’s interest rate hikes thus far have come gradually and tentatively, following a prolonged recovery from the worst recession in 100 years. The Fed has been cautious with upward movements in interest rates, not wanting to put the brakes on the economy prematurely. Since the Fed began interest rate hikes on roughly a quarterly schedule, the economy has continued to show broad strength, with consecutive months of aggregate job growth nearing record highs.

In other words, rising interest rates have not occurred in a vacuum so far, and will not happen regardless of other macroeconomic factors in the near future. The overall health of the economy still augurs well for commercial real estate investors. Asked to name a near-term threat to the U.S. economy (and, hence, commercial real estate markets), most experts would cite souring international trade relations and geopolitical volatility well above interest rates, which tend to rise in reaction to observed macroeconomic factors, rather than have direct macroeconomic impact.

interest rates and real estate - job market still key.

Source: Bloomberg

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. Rent growth is still expected in the near and medium-term in many markets, such as supply-constrained metros with growing populations and positive job growth forecasts, like Los Angeles. Rent growth is also expected in many secondary and tertiary markets with strong labor market demand drivers and appealing cost and quality of living versus gateway cities, such as Portland, OR or Provo, UT.

Asset class matters as well when considering cap rates – and their vulnerability to incremental increases in cost of capital. As of this writing, retail appears to be somewhat susceptible to rising cap rates, as does multifamily in certain gateway submarkets that have shown signs of overheating. On the other side of the coin, industrial and alternative sub-asset classes (like manufactured housing and self-storage) seem primed for further rent growth. And in the lodging industry, room rates are anticipated to continue climbing.

In sum, increases in cap rates may accompany interest rate hikes, but this is a hardly a one-to-one, cause-and-effect relationship. And, this observed correlation does not hold true uniformly across markets and property types. 

NOI Growth & Long Investment Horizons

As we’ve written about before, 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. Rental income and NOI growth remain above average for most property types, except for retail, indicating that most asset classes will withstand rising cap rates in the near term.    

Individual investors considering investments through platforms like EquityMultiple may want to consider equity investments with healthy target cash flow throughout the term.

By Soren Godbersen
VP | Marketing & Communications
Soren heads up all EquityMultiple communication efforts, including educational materials and research.
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