The Prospects of Rising Interest Rates on Commercial Real Estate
For nearly a decade the Federal Reserve Bank has reduced or held its interest rate target steady. That ended December, 2015 with the Fed increasing its target range by 25 basis points. Thirty days after the Fed raised, the market appeared to be strongly questioning the efficacy of such a move. The stock market crashed, the price of oil fell below $30 a barrel (down from $100), and inflation was nowhere in sight, and most of the world’s central bankers were all in with various forms of quantitative easing. Japan, Sweden and Italy experimenting with negative interest rates as an example. And, general interest rates went down, with the 10-year Treasury yield falling below 1.7% in February.
Now fed funds futures appear to be telling us of a 19% chance the fed raises rates in March and a 50% chance they raise at all in 2016. But in anticipation of if/when rates do rise, investors should have a game plan for managing the impact higher rates might have on their CRE portfolios. What actually will happen is hard to tell since the variables are many and not neatly correlated with each other. However, thinking through the metrics of how interest rates and commercial real estate values interact should facilitate developing asset management strategies.
Increasing Rents and Interest Rates
Overall, increases in indices (T-bills, corporate bonds) should have adverse effect on all yield oriented investments. However, the relationship with CRE is more complicated – specifically, unlike most bonds, cash flow can increase for CRE during the term, and potentially offset the negative effects of higher interest rates on cash flow. What matters here is the context of the interest rate change. Interest rates typically increase when there is an expectation of looming inflation. And inflation is typically good for CRE as many leases are equipped with CPI bumps and other increase provisions. Achieving CRE rent increases in the shorter term depends on the structure of the rent roll. Smaller tenants with shorter lease terms, properties with higher vacancy and leases with operating expense pass-throughs allow an operator to more rapidly increase rents and NOI in an improving economy. This opportunity can be exacerbated by a lack of new supply, such as we are seeing in many markets where new bank regulation has made it more difficult for developers to find construction financing. Those structural elements of CRE leases allows rent growth to occur and thus value to increase in spite of higher interest rates. Obviously, this holds true for stable markets with supply and demand in equilibrium and stable cap rates.
Cap Rates and Interest Rates
Philosophies vary regarding the correlation between cap rates and indices, i.e. T-Bills and corporate bonds, but historically that relationship is tenuous. A cap rate simply compares property income to overall value. Cap rates are affected by many things including, but not limited to: market fundamentals, or supply and demand equilibrium, availability of credit, investors required rate of return, or RROR, and investors perception of CRE risk premiums.
A recent phenomenon (but repeated from various time in the past, i.e. the Japanese acquisition spree of the 1980’s) is the funds flow to the CRE sector. Domestically, we have heard anecdotally many pension funds increasing allocations to CRE investing for 2016, which will be capital invested on top of unused allocations from 2015. Internationally, some foreign funds flow is driven by the desire to get foreign capital out of the country and away from despotic dictators threatening to seize the capital. The foreign investors paradigm is something akin to, “it’s better to overpay for US CRE by 20% than risk losing 100% of my investment capital to my ruler,” and thus upward pricing on U.S. CRE is exerted. I playfully refer to this as legalized money laundering. Recent changes to U.S. legislation involving FIRPTA regulations has made it easier on our side for qualified foreign pension funds to invest in U.S. CRE. Some funds estimate that these changes will add as much as 150 basis points of yield to their U.S. CRE investments. On top of FIRPTA rule changes, the EB-5 immigrant investor visa program is expected to stimulate investment in U.S. CRE by an additional $4-5B in 2016 alone. In my daily conversations with market pros the overwhelming sentiment at the current moment is that the funds flow to U.S. CRE will increase in 2016, keeping CRE asset prices strong and cap rates low.
Whether a cap rate will increase along with interest rates is really an interaction of rent growth versus an investors increase in RROR and his perceived risk premium for CRE. RROR is a function of alternative investment opportunities and the USA is seen by the rest of the world as a safe harbor. However, a potential headwind here is the widening of corporate bonds, especially in the lower investment grades and higher non-investment grade tranche’s. If these widen much more is possible to see some funds flow toward those bonds and away from CRE. It’s also possible that the rash of recent legislation that is Basel III and Dodd-Frank risk retention rules will drain some liquidity from the pool, and exert some measure of downward pricing on CRE values. At this point it appears the increasing funds flow will subsume the slightly reduced liquidity from the debt markets.
Historical Relationship of Cap Rates and Indices
Prudential did a study a few years ago that looked at the last 6 periods of extended rising interest rates and found that cap rates were relatively unchanged in absolute terms during those periods, but the spread between cap rates and T-bills narrowed significantly. The conclusion was that during periods of rising interest rates, the economy is better and so space fundamentals are better causing rent growth, and investors have greater appetite for risk. Thus the narrowing of the spread between cap rates and interest rates absorbed the impact of higher interest rates and property values were maintained or even expanded. Over the past 6 years the spread of cap rates over T-bills have been wider than the average over the past 20 years. So we have room for compression if rates were to rise.
About all that’s certain is that we can be certain about very little. However, keeping your finger on the pulse of why interest rates may rise might give you a leg up on exercising a solution option you may not have after it’s too late.
