Interest Rates and Cap Rates Aren’t Always Correlated
Cash Flow, CRE Fundamentals Pose Strong Counter Punch to Potential Rate Increase Impact on CRE Values According to Accounting Firm
As the Federal Reserve readies an expected decision this week on whether to begin raising interest rates, common assumptions among some commercial real estate investors, developers and lenders are that CRE values will take a hit when interest rates are raised.
The basis for this assumption appears intuitive at first. Rising benchmark interest rates, like Treasuries, should tend to make all yield-oriented investments to be less attractive,
However, according to a new report issued this week by accounting firm EY, the relationship between interest rates and CRE values is much more nuanced. While the Fed’s initial policy adjustments likely will have a marginal impact on CRE valuations and investment momentum, interest rates and cap rates aren’t always correlated, the EY report authors claim.
Several factors affect the trajectory of capitalization rates and real estate values, such as demand and supply changes, transaction activity and trends in the overall economy. An in the current market, CRE fundamentals are strong.
At the worst, EY predicts, an uptick in the federal funds rate may make it more expensive to develop new projects and refinance certain debt, and possibly cause a reactionary sell-off in publicly traded real estate investment trusts (REITs).
However, as it currently stands, relative to historical averages over the last 30 years, the spread between the 10-year Treasury and CRE yields appears to allow for further compression. This suggests that CRE values are not immediately threatened by rising interest rates, EY said.
The EY report was authored by members of EY’s real estate M&A advisory team led by Steve Rado, a principal in Ernst & Young LLP’s Transaction Advisory Services practice, with contributing author Dr. W. Michael Cox, the former chief economist of the Dallas Federal Reserve Bank and a professor at Southern Methodist University’s Cox School of Business.
EY noted several drivers that are expected to buttress real estate values, including record amounts of inbound capital, available private equity ‘dry powder’ for investment, a generally positive economic outlook with some obvious caveats, and relatively strong CRE fundamentals.
A 25 to 50 BPS Jump Doesn’t a Spike Make
A shock to the U.S. CRE investment environment from a 25 to 50 bps increase in the overnight lending rate seems unlikely in light of the forecasted environment for the sector, according to EY. With vacancies trending down in office, retail and industrial properties and hospitality and multifamily exhibiting increased rents, the report’s authors expect the effect of contractionary monetary policy and rising interest rates on real estate values and cap rates to be mitigated in the near term, especially for investors focused on cash flows from higher lease rates and strengthened property operations.
While many observers purport a negative outlook for CRE based on the premise of a spike in long-term interest rates, the possibility that long-term interest rates will see only moderate increase over the near term is more likely given the slower pace of the U.S. economic recovery, the EY analysts said.
They also expect CRE will continue to be an attractive investment on a risk-adjusted basis in the near-term, given current conditions of increased capital supply and strong fundamentals, along with room for compression in the spread between cap rates and interest rates, according to the report.
However, EY cautioned investors on underwriting risk as trophy assets in gateway markets appear to be fully priced with new supply is coming on the market at a faster pace.
Finally, the EY report authors urged investors to see the glass as half-full rather than half-empty.
“Actions of the Fed to normalize interest rates should not be seen as a bane for the industry, but rather should instill confidence that their efforts are a proactive measure to provide stability in the future,” the EY report concluded.