Real estate investors have been eyeing rising interest rates with caution after nearly a decade of surging investment volumes.
While investment is expected to remain strong this year, investors are acutely aware that rapid hikes, over time, can increase capitalization rates and lower property valuations, leading to a buyer’s market.
Now that results are in from Wednesday’s Federal Reserve Board meeting – its first under new Chairman Jerome Powell — investors are “cautiously optimistic,” says Ryan Severino, Chief Economist at JLL.
The Fed voted unanimously to raise short-term interest rates by a quarter-point and indicated that the pace of rate increases will be more aggressive over the next two years than what was projected during its last meeting.
Seven out of the 15 participating Fed officials now expect at least four rate increases this year, instead of the three hikes that were forecast in December.
While incremental hikes don’t have much of an impact on commercial real estate, the cumulative impact of increased rates, over time, can become a drag on the economy, Severino says.
“In the long term, property values would be impacted if the Fed breaks with conventional wisdom by raising rates too often or too high,” he says.
Real estate implications
Certain commercial property types are more sensitive than others to these increases.
Investments with fixed income characteristics, such as net lease properties, are more at risk. Tenants at these sites, which include retail outparcel lots located near shopping centers, consistently pay a fixed monthly rent, which can decrease in value as interest rates rise, according to Severino.
Meanwhile, properties that have more equity-like characteristics are better able to ride out interest rate increases because “the cash flows grow along with the overall economy,” Severino says.
An even safer bet is debt. Amid caution over rising rates, real estate investors are also pushing into the debt market, seeking lower-risk opportunities. Real estate debt funds last year raised US$28.6 billion, up from US$23.6 billion in 2016 and US$18.3 billion in 2015, according to Preqin.
Because debt lenders sit lower in the capital stack than equity investors, they can better avoid losses if property valuations come under pressure.
It’s all about the cycle
“Some of the headwinds the U.S. economy faced in previous years have turned into tailwinds,” Powell said in his first remarks to Congress on Feb. 27, citing concerns about fiscal stimulus overheating the economy.
The strong February jobs report, coupled with the most recent Consumer Price Index summary — which shows a 2.2 percent gain over the past 12 months — appears to bear out Powell’s positive economic outlook.
The Fed’s latest hike raised rates by 25 basis points to a range of 1.5% to 1.75%. The board expects to raise the rate in 2019 slightly faster than previously expected, to 2.9%.
Going from zero basis points to 25, or even to 50 in a low interest rate environment, is not perceived as a big deal, Severino says.
At some point, though, cumulatively, “we could reach an interest rate that goes from being somewhat conducive to economic growth to a neutral point or a somewhat contractive [one]. You don’t really know where it is.”