Interest rates have a profound impact on the commercial real estate market as a whole. The Federal Reserve recently increased its benchmark interest rate and announced plans to raise rates twice more by the end of 2017. As a result, market participants will continue to pay close attention to rate changes when analyzing the future state of the commercial real estate market and property performance.
Interest-related factors that influence property values include mortgage rates, capital flows, supply and demand for capital, and investor’s required rates of return on investment. Many investors worry that increasing interest rates will apply upward pressure on capitalization (cap) rates, resulting in declining property values. However, it is critical to understand the numerous other variables at play in a rising interest rate environment.
Defining Interest Rate
The interest rate is essentially a leasing charge applied to the principal amount that is borrowed from a lender for the use of assets. Interest serves as compensation for the lender’s loss of the asset’s use and is typically expressed as an annual percentage rate (APR). A borrower with low credit risk will typically be charged a lower interest rate, while higher rates are normally charged to higher-risk parties.
The simple interest formula = P (principal) x I (annual interest rate) x N (years)
The compound interest formula = P (principal) x [(1 + I (interest rate) N (months)) – 1]
The Impact of Interest Rates on Commercial Real Estate Returns
Due to the recent increase in interest along with the Fed’s announcement to continue increases throughout 2017, commercial real estate investors are worried that investment returns may be derailed by weakening property values and performance. However, historical data suggests that higher interest rates do not necessarily spoil commercial real estate total returns. The National Council of Real Estate Fiduciaries Property Index (NPI)—which is widely regarded as a performance benchmark for institutional-grade commercial real estate—shows the cyclical nature of real estate returns over time and solid performance following the Great Recession. The overlay of NPI total returns and the 10-year Treasury yields during the recovery stage following the Great Recession are evidence that commercial real estate performance displays resilience during the presence of rising interest rates.
Interest Rates in Relation to Cap Rates
Cap rates are a key metric of the commercial real estate market and are expressed as the ratio of a property’s net operating income (NOI) to its market value. Investors have historically expressed concern regarding a potential direct correlation between rising interest rates and increasing cap rates, ultimately resulting in the decrease of property values. However, the relationship between interest rates and cap rates is too complex to be analyzed in a vacuum. There are many other variables at play. Furthermore, the relationship between NPI transaction cap rates and 10-year Treasury yields over a 22-year period (1993 – 2015) has shown that the correlation between cap rates and treasury yields is a moderate 0.7 rather than a perfect 1.0.
There is a lack of evidence that displays any sort of compelling relationship between Treasury yields and cap rates, which suggests that cap rates are impacted by multiple variables outside of interest rates, such a capital flows, investor risk threshold, and real estate market fundamentals. As such, the impact of rising interest rates on income-producing properties is challenging to predict.
Key Protection Factors
Multiple factors provide protection to commercial real estate performance in a rising interest rate environment. The difference between cap rates and 10-year Treasury yields can serve as a buffer to offset potential property value decreases when Treasury yields and/or cap rates slightly fluctuate. In addition to the spread margin that is able to protect real estate, rate increases often signal a strengthening economic environment. Even when interest rates rise, commercial real estate performance can benefit from job growth, wage growth, and a potential boost in gross domestic product (GDP).
Underwriting methods also serve as a protection factor as cap rates are usually projected to increase by 50 – 100 basis points over the course of the holding period. This increase reflects the aging life of real estate and effectively removes some of the surprise associated with rising cap rates.
Although the Fed has announced its plan to further increase interest rates over the course of 2017, rates are still relatively low and borrowing conditions remain favorable. Strong domestic and foreign investor sentiment towards the United States commercial real estate market is expected to continue into the foreseeable future. In addition, forecasts of limited new construction in conjunction with healthy job growth, is anticipated to result in the continuation of healthy fundamentals. It is important to note that financial markets are volatile, and real estate is historically cyclical.