With rates beginning to rise—and likely to continue—investors need to understand how commercial real estate could be affected.
Interest rates have remained at historically low levels for so long that many investors may feel uneasy about the rise of rates. That's particularly true for clients who invest in U.S. commercial real estate, or may want to in the future. There's a natural tendency to think that rising rates will make commercial real estate holdings less valuable and generate less income. Yet a closer look at the data, including historical performance during previous periods when rates were rising, shows that's not the case. Moreover, real estate has proven to be a good hedge during high-inflation periods (i.e., times when rates were already high and stayed high). To understand why, you need to consider how different aspects of the economy are all connected.
First, here's a quick thought experiment. If you could freeze everything in the economy, an increase in interest rates would clearly lead to a drop in commercial real estate values. Investors typically borrow money to finance real estate purchases. Rising rates means that borrowing money simply costs more. In addition, rising rates reduce the value of the future cash flow received by real estate owners. Tenants pay the same amount in absolute terms, but rising rates mean that the cash flow needs to be discounted due to the increase in interest on borrowed capital.
But that's not the end of the story.
In the real world, interest rates can't be considered in isolation. Rising rates are linked to a lot of other variables, and collectively, those variables can reduce—or even completely overcome—the potentially negative effect of rising rates. There are several reasons why.
First, rates usually rise because overall economic conditions are improving. Currently the U.S. economy is seeing low unemployment, solid GDP growth and strong corporate profits. That kind of positive business activity suggests that commercial real estate owners may see an increase in occupancy and rent growth percentages.
Second, rising rates are often linked to inflation. (In fact, increasing rates is one way that the Federal Reserve puts the brakes on inflation due to economic growth.) Inflation means higher prices for goods and services, and it also means an increase in the value of hard assets like commercial real estate. This is especially true of properties that have short-term leases that can increase their rent, leading to more income from a given asset. For these reasons, commercial real estate has been a good hedge against inflation in the past.
If you look at the last eight periods in which the U.S. 10-year Treasury yield increased by one percentage point or more, the total return on real estate increased in seven of those periods. (The sole exception was the financial crisis of 2008, which was directly tied to real estate.) Moreover, the change in real estate returns for the 12 months following a rate increase was positive in all eight periods.1, 2
Real Estate Performance Indicators During Periods of Rising Interest Rates
Data represent eight time periods between 01 Jan 1987 and 31 March 2018 when the U.S. 10-year Treasury yield increased by 100 basis points or more. It is not possible to invest in an index. Performance for indices does not reflect investment fees or transaction costs.
SOURCE: "Think US: The Impact of Rising Interest Rates on Commercial Real Estate," TH Real Estate, June 2018.
Overall, commercial real estate is a complex category, and investors need to understand the risks and how specific economic factors can affect performance. Many factors are highly local, including market conditions, the quality of properties, the amount of inventory and demand, and other aspects. And, of course, prior performance does not guarantee future results.
A look at historical performance shows that the conventional wisdom about commercial real estate—that it takes a big hit when interest rates rise—is simply not true. As the data show, the asset category has actually performed better during periods when rates are increasing (like now) or when rates remain stable and high. For investors thinking about the asset class, it pays to look past the conventional wisdom.
1 "Think US: The Impact of Rising Interest Rates on Commercial Real Estate," TH Real Estate, June 2018.
2 Past performance is no guarantee of future results. The indices used represent investments that are materially dissimilar to non-traded REITs which, have a higher fee structure and risk level, longer time horizon, different tax treatments and fewer liquidity options. An investment cannot be made in an index. Commercial real estate is represented by the NCREIF Property Index (NPI). These indices reflect leverage and fund expenses, but do not reflect management, investment or advisory fees. If they did, returns would be materially lower. Performance could be impacted by the use of different time periods.
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