Commercial real estate has prospered so well in the low interest rate environment that the likelihood of rising rates in 2016 is cause for worry among investors. The concern is that real estate values will fall as interest rates rise.
However, there are many reasons that we feel those fears will not come to fruition and commercial real estate will prove to be resilient. Historically, the increase in the federal funds rate does not necessarily mean the same for Treasury rates; the correlation between interest rates and real estate prices is surprisingly weak; and real estate fundamentals do not show any sign of weakening.
Let's look at these issues one by one:
Will Treasury Rates Rise?
Commercial real estate is priced off of the 10-year Treasury rate, which is not the same as the federal funds rate controlled by the Fed. Treasury yields are near long-term lows mainly because of demand from foreign investors engaged in a flight to safety. With all the questions faced by countries around the globe – Europe struggling under the burden of low growth and terrorism, Asia and emerging markets facing economic slowdowns and low commodity prices, the impact of lower oil prices in energy-reliant countries – U.S. Treasuries are likely to remain in high demand, keeping rates low.
Correlation is Weak
Real estate values are driven by two components: capitalization rates (the initial yield for the investor at purchase) and appreciation. When investors demand higher “cap rates” (yields) to buy assets, it in effect lowers property values. The cap rate is typically based on a spread over Treasuries, so when Treasury yields go up it seems logical that real estate yields would rise, reducing values. Over the past few decades, however, when interest rates have risen rapidly, commercial real estate prices have remained stable or even gone up.
That might seem counter-intuitive at first blush, but the fact is that interest rates are only one of a number of components that go into the pricing of real estate. Short-term interest rates tend to rise when the economy is strong, so when rates are going up investors expect that rents and values will go up as well. In other words, investors are willing to pay more when they are bullish on the prospect for increased property incomes. Another factor is the price of alternative investments. Commercial real estate currently returns more than bonds or other investment sectors on an absolute and a risk-adjusted basis, so investors seeking high yields have few other options.
What would hurt commercial real estate prices the most is poor performance. There are a number of reasons to believe, however, that the sector's recent upswing is not running out of steam. For one thing, most economists feel the recovery in the U.S. has another few years to go. The economy is continuing to produce 200,000 jobs a month, which is a key factor in the strong demand for commercial properties. And unlike previous real estate boom cycles, the market is not suffering from overbuilding. The market is coming off of a half-decade of underdevelopment, and it will take some time to get back to equilibrium, let alone the over-development phase. Plus, the crisis that produced the last recession has led to banking reforms that has reduced the availability of construction debt.
The upshot is that past history of the sector and the future prospects for fundamentals makes it unlikely that the slow increase in interest rates envisioned by key policymakers will have any immediate or major impact on commercial real estate prices.