Impact of Rising Interest Rates: Experts Agree, It’s Probably a Good Thing
After much anticipation for the duration of 2016, it wasn’t until Dec. 14, 2016 that the FED finally raised rates by 0.25%. Three months later, they did it again. On March 15, 2017, the FED raised interest rates another quarter-point to between 0.75 percent and 1 percent, reported The New York Times.
According to CoStar, the common correlation between higher interest rates and higher capitalization rates, and thereby lower property values, may no longer stand. New research from TH Real Estate, a division of pension fund investment manager TIAA Global Asset Management, “calls into question a direct link between the two. In fact, the report finds that rising interest rates have not automatically resulted in lower real estate values or total returns as many investors assume.”
I recently spoke with a panel of experts on The Commercial Real Estate Show to gather opinions on what these increases could mean for commercial real estate, how much rates will rise and how fast.
Are Interest Rates Rising? Yes. Do we panic? No.
In early December, prior to the rate increase, Barbara Denham, an Economist with REIS, predicted three 25 basis point increases between then and the end of 2017. So far, she’s two for three. In her opinion, an increase in interest rates isn’t a negative thing but instead is indicative of strong job growth, inflation and wage increases. “More inflation isn't necessarily a bad thing and I've always thought higher interest rates usually reflect a growing economy,” she said.
235,000 jobs were added in February, and the unemployment rate was little changed at 4.7 percent, according to the U.S. Bureau of Labor Statistics.
Lisa Pendergast, Executive Director of the CRE Finance Council, thinks that any rise in interest rates will be offset by growth in the economy and that rising interest rates are a positive thing especially for banks, financing, CMBS and “the whole finance world” in general, since higher interest rates basically make the banks healthier.
Andrew Warren, Director of Real Estate Research at PwC, joked, “Why would I be afraid of rising rates as a real estate owner? Don’t rising rates mean the economy is doing better?”
We’re Going Off Book/ The Big Picture
Almost all of the experts I spoke with referenced the big picture. Specifically, the fact that, historically speaking, interest rates were the lowest they have ever been, so a slight increase this year won’t be a problem.
However, history doesn’t always repeat itself. Keeping with the recent findings that rising interest rates don’t necessarily impact values the way they used to, Denham said the impact on cap rates may not be as “textbook directional” as it is as it has been in the past, because the economy is working in a new way. The textbook definition is that low interest rates drive inflation, however we haven’t had inflation despite “rock bottom” interest rates.
Elaine Marin, Director of Research with Grosvenor Americas agreed that we won’t immediately see an “across the board” increase in cap rates as a result of what's going on the Treasury side.
Mitch Roschelle, Partner at PwC, is always especially good at looking at the big picture: “We created more supply of commercial real estate and residential real estate when interest rates were twice what they are right now maybe three times what they are right now.” He goes as far as to suggest that interest rates largely won’t impact real estate: “I think it's all about the supply and demand of capital and [the questions of] ‘Will underwriting standards change?’, ‘Will more debt be available in a higher rate environment?’…that's what's going to truly impact real estate.”
“If you look at the history of cap rates and how they behave relative to the 10-year Treasury, (which is the standard benchmark), they don't move in lockstep,” said Marin. The average cap rate spread over Treasuries is above the long-term average right now.
Because of this spread, Marin thinks there’s room for more compression before you see a significant move up in cap rates. Marin mentions investor confidence and an optimistic outlook as other potential factors that could affect commercial real estate values. Marin thinks the 10-year Treasury will go up and get close to about 4 percent late 2018, maybe into 2019.
Warren also mentioned the historically high spread over the 10-year Treasury as a reason we can absorb rising interest rates. He said rates would have to rise by three percent before you really start to see a hit. “If we go up one percent, I think the market can absorb that without blinking…” Warren guesses that the Federal Reserve’s benchmark rate will be 3.5 to 4 percent in two years.
The Other Variables
Pendergast said that as the rate interest rate/ cap rate correlation goes, that the cap rate is only one variable affecting value. There are other variables to be considered. Are you seeing higher occupancy rates? Are you able to raise rents because the economy is doing better? The companies that would be tenants in your property, are doing better, therefore they can manage that increase in rental costs.
Clearly, it’s impossible to look at rising interest rates without looking at these other variables. The new administration, investor confidence and behaviors, underwriting and the housing market all play a part in what the future holds for commercial real estate.
Pendergast mentioned the corporate stimulus promised by President Trump, who plans to cut the corporate tax rate from 39 percent to 15 percent, (some say it might be 20). Regardless, any cut to corporate tax rate will act as stimulus. In addition, the Trump administration is discussing 1 trillion in infrastructure spending.
David Lynn, CEO of Everest High Income Property, agrees an “ambitious national infrastructure program with a lot of spending,” could potentially cause higher inflation. Secondly, if tariffs are raised on more of our imports, that could cause higher inflation. “Both of those things could cause higher interest rates, as well as just general improving economic health and higher growth…” he said.
Roschelle points to investor behavior as the key to the future. “The chase for yield has been happening in a period of falling interest rates and that drove a lot of investors to real estate because they felt like they got more yield, they got more total return investing in real estate than they may have gotten from an alternative income-producing asset class.”
He asks, “In a period of rising rates do investors chase yield and chase it to real estate? Or do they run away from real estate?” Of course, he can’t answer this for sure but he says, “My fundamental belief would be, if you like the risk profile of real estate today, why wouldn't you like it when rates go up?”
Lynn asks, “What are the other alternatives available to investors? The answer is that they're not that many providing high returns. Essentially, real estate is still safe and it’s unlikely that investors will simply abandon it.
In addition to interest rate increases, we have seen some tightening of underwriting. It’s impossible to ignore how the Dodd-Frank bill has affected underwriting and the fact that some borrowers are having a tougher time getting loans approved.
Pendergast said the Dodd-Frank risk retention rule, which requires CMBS issuers to retain 5% of a transaction, started on Dec. 24, 2016 – the idea is that you have “skin in the game,” to make for better underwriting. Risk retention will be in full effect throughout 2017 as all the 10-year loans that were originated in 2007 mature. “Because of risk retention, one would argue that credit underwriting will be more conservative than it has historically,” she said.
“We've all felt that the recovery has been a little lackluster, so the fact that we see increased growth or could see increased growth, due to corporate tax cuts and deregulation and many of the things which we've heard since the election, then you could argue that you’ll start to see a more robust environment, which is positive for commercial real estate,” said Pendergast. “Your refinancing may cost you more, but the hope is that the income coming off of your real estate is going to rise along with the growth that you're seeing in the macroeconomy.”
Pendergast said there's been a good amount of new development in commercial real estate –certainly for multifamily and the homeownership rate continues to be one of the lowest we've had historically. She speculates that demand for multifamily and these new developments will remain quite strong and Fannie Mae, Freddie Mac and Ginnie Mae are providing attractive financing at attractive rates to multifamily property owners. “There's no question that you'll see rising mortgage rates throughout the balance of next year,” she said.
Denham said the proportionate impact of higher interest rates on mortgage rates might spur some home buying in the early part of 2017, as potential homeowners will be trying to secure a mortgage before interest rates go up more. And homebuyers are great for the U.S. economy and therefore for commercial real estate.
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