Understanding Commercial Property Valuations in a Rising Interest Rate Environment

Introduction: understanding the interest rate environment.

As the Federal Reserve looks to normalise monetary policy after a sustained period of exceptionally low interest rates, some commercial real estate (real estate) investors, developers and lenders are worried that real estate values will be negatively affected under the assumption that when interest rates rise, real estate values will fall.

This relationship seems intuitive at first — rising benchmark interest rates, like Treasuries, should cause all yield-oriented investments to be less attractive. On closer examination, however, the relationship between interest rates and real estate values is much more nuanced. The trajectory of capitalization rates (cap rates) and real estate values is also impacted by other significant drivers like, demand and supply changes, transaction activity and trends in the overall economy.

At the broadest level, an uptick in the federal funds rate may make it more expensive to develop new projects and refinance certain debt, and possibly engender a reactionary sell-off in publicly traded real estate investment trusts (REITs).

Relative to historical averages over the last 30 years, the spread between the 10-year Treasury and real estate yields appears to allow room for further compression, and this suggests that real estate values are not immediately threatened by rising interest rates. This seems especially so as other forces buttress real estate values, like record amounts of inbound capital, available private equity “dry powder,” a generally positive economic outlook and strong real estate fundamentals.

The almighty capitalisation rate.

Apartment capitalisation rates have compressed substantially since the end of 2010, primarily in the global “gateway” markets, such as New York City, Los Angeles, and San Francisco, which have seen cap rates on A grade complexes as low as three percent.

There is a fear amongst some that a sudden spike in interest rates will translate into an immediate jump in cap rates. While it is true that in the long term, cap rates will eventually adjust upward to compensate for the higher financing costs associated with rising interest rates. Base on current information and historical experience the long term is a long way away.

Rising interest rates will not immediately threaten real estate values.

With a change to monetary policy looming, some have suggested that this will mark the beginning of the end of the current strong real estate cycle. There are at least five reasons to consider why this may not be the case:

Historically, there has been no strong correlation between the 10-year Treasury yield and real estate cap rates, and the current spread remains wider than historical averages, suggesting room for compression.

The impetus for the Fed’s expected rate hike is improving domestic economic performance.

Improving economic conditions should engender stronger real estate fundamentals.

Capital flowing into US real estate continues to be robust.

A rise in the federal funds rate may not have a substantial near-term impact on the cost of many types of real estate debt.

Interest rates and capitalisation rates are not always correlated.

Conventional wisdom in the industry is that when US bond yields and interest rates move, cap rate movements will mirror this trajectory, indicating that the two variables are strongly correlated. However, cap rates and Treasury yields historically have not exhibited a strong correlation, even when analyzing their trajectories dating back several decades.1 In fact, from the 1980s to present day, there have been several instances where cap rates and Treasury yields moved in opposing directions (see Exhibit 1). While cap rates and interest rates do not appear to exhibit a significant correlation, there is meaningful insight to be gleaned from examining the spread between these two yields.

Exhibit 1: Capitalisation rates have not demonstrated a strong correlation with US Treasury yields.


 


There is room for compression between 10-year Treasury yields and capitalisation rates.

The 10-year Treasury rate and cap rate spread is useful because it illustrates the risk premium the market demands in excess of a perceived “riskless rate” (i.e.US Government bonds) to invest in real estate.

The narrower the spread, the greater the investor appetite for real estate yields, suggesting a higher risk tolerance. For the major real estate property types, the spread at the end of the second quarter of 2015 was larger than the historical average spread of the last 30 years (from 1986 to the second quarter of 2015). The current spread is also larger than the historically tight spreads that preceded the last peak in July 2007 — and the recession that followed. This suggests that there is room for further compression between Treasury yields and cap rates before the health of the asset class is measurably impaired (see Exhibit 2).

Exhibit 2: The 2Q 2015 average spread between cap rates and the 10-year Treasury yield was larger than the long run average spread and the lows in 2Q 2007.

Product type

Average spread:
2Q 1986–2Q 2015

2Q 2015 spread

2Q 2007 spread

Office

257 bps

290 bps

1 bps

Industrial

304 bps

366 bps

134 bps

Retail

269 bps

350 bps

102 bps

Apartments

231 bps

276 bps

49 bps

Hotel

499 bps*

524 bps

307 bps

Average

286 bps

361 bps

119 bps

*Hotel data begins in 4Q 2003.

Source: Federal Reserve Economic Data, St. Louis Fed, 2015; Green Street Advisors, 2015.


Apartments are maintaining, healthy cap rate spreads to risk-free rate and a significant spread above prior peak levels.

 


It seems likely that the market will be able to absorb incremental rate increases given that the current spread is wider than the long run average, underlying fundamentals are strong and there are other market forces that continue to drive demand to the real estate asset class resulting in lower cap rates and rising valuations. 

Improving economic conditions bode well for real estate.

When the Federal Reserve enacts contractionary monetary policy, it is generally due to high inflation expectations, improving domestic economic conditions or a combination of both factors.

Inflation expectations.

While rising interest rates and higher costs of capital are an obvious concern to those investing in real estate, the asset class is an attractive investment because it generally is viewed as a hedge against inflation.

This is especially true for property types with shorter lease durations or those that have the ability to reset rates more frequently, such as apartments and hospitality.

Property types with longer-term leases, such as office and retail, may also have rent structures with escalations tied to the consumer price index (CPI) and thereby provide inflationary protection.

However, this characteristic of real estate investments will not likely be the force that drives capital to the asset class in the near term as US inflation expectations remain low, and actual reported inflation measures have been well below the Fed’s formal inflation target of 2%. In fact, inflation expectations, as indicated by the historical 10-year Treasury Inflation-Protected Security break-even rate, consistently have fallen since 2013 (see Exhibit 3). The Fed’s own forecasts do not expect Personal Consumption Expenditures Inflation to rise above 2% in the long run (see Exhibit 4).  

Exhibit 3: Historical 10-year Treasury Inflation-Protected Security break-even indicates declining inflation expectations.

 


Exhibit 4. Personal Consumption Expenditures Inflation Forecast. 


PCE Inflation—as measured by the change in the personal consumption expenditures (PCE) price index from the fourth quarter of the previous year to the fourth quarter of the year indicated, with values plotted at the end of each year.

Source: Projections – Board of Governors of Federal Reserve December 16 2015

 

Economic indicators point towards growth.

While uncertainties abound surrounding wage growth and declines in labor participation rates, the overall economic picture appears positive, and this ultimately bodes well for real estate. Two major indicators of domestic economic growth, the US unemployment rate and the monthly change in US nonfarm payrolls, have been trending positive. From January 2012 to July 2015, unemployment fell 3 percentage points, from 8.3% to 5.3% (see Exhibit 5).

Exhibit 5: The US unemployment rate has consistently declined in recent years.


Source: U.S. Bureau of Labor Statistics January 8, 2016

Similarly, changes in nonfarm payrolls, which account for 80% of all US workers, have increased year-over-year since 2011, implying improving levels of job growth each year (see Exhibit 6). As the economy improves, so too will real estate values.

 

Exhibit 6 The US unemployment rate has consistently declined in recent years.


New residential housing starts, one of the most closely watched leading economic indicators, reached an eight-year high in July 2015. The US Commerce Department reported that new housing unit starts reached a seasonally adjusted annual rate of 1.2 million, an increase of 10.1% compared to a year ago and 35.3% compared to 2013 (see Exhibit 6).

 

Exhibit 7: New residential housing starts have approached an eight year high.

 

Given this outlook, it that the recently announced 0.25% interest rate hike will not be driven by inflation at this time.

It is important to keep in mind the difference between real returns and nominal returns with regards to interest rates. A real return represents a return that increases an investor’s overall raw purchasing power, whereas nominal returns represent the real return plus a rate of expected inflation.

Commercial real estate provides protection only from the inflationary component of nominal interest rates.

Holding all other influencing factors constant, a rise in real interest rates would negatively impact real estate values regardless of the lease structure, as a rise in real interest rates would, in theory, cause property valuation discount rates to increase in kind, negatively impacting the value of discounted future cash flows. In reality, all other influencing factors are not held constant and low near-term inflation expectations are coupled with improving domestic economic conditions, which are the basis for solid commercial real estate fundamentals.

 

Real estate fundamentals are strong.

In recent years, occupancies have continued to improve while effective rents are growing across the four primary property types (see Exhibit 8). Hotels occupancies and average daily rates (ADRs) have risen past 2007 levels to 67% occupancy and $120 ADR.

Exhibit 8: Since 2012, occupancies and rents have increased.


Occupancy, year-over-year change

 

Apartments

Industrial

Retail

Office

2012

70 bps

90 bps

30 bps

30 bps

2013

30 bps

50 bps

30 bps

20 bps

2014

0 bps

50 bps

20 bps

20 bps

2Q2015

10 bps

30 bps

10 bps

10 bps

 

Effective rent growth, year-over-year change

 

Apartments

Industrial

Retail

Office

2012

3.9%

1.7%

0.5%

2.0%

2013

3.3%

2.1%

1.5%

2.2%

2014

3.7%

2.5%

2.0%

3.0%

2Q2015

1.9%

3.1%

1.1%

1.7%

 

Source: 2Q 2015 Metro Trends, REIS, Inc, 2015.

 

Examining the apartment pipeline: a delicate balance.

The balance between supply in the pipeline and demand from multifamily apartments has a profound impact on cap rates. If fundamentals remain strong, demand will follow. The new supply of apartments measured in construction starts, is below recent peaks and long-run averages. This fact, coupled with continued positive absorption, demonstrates that there is still runway left for construction and new supply before reaching equilibrium. 

Indeed CBRE reports that the apartment sector posted another quarter of strong fundamentals in Q3 2015, along with significant investment activity and competitive pricing. Employment growth and demographically driven demand handily worked through new deliveries to produce a seventh consecutive quarter of positive net absorption. This strong absorption belies a U.S. homeownership rate that remains close to all-time lows—though it increased in Q3 for the first time in seven quarters. 

Year-over-year rent growth was stable and strong, averaging 3.8%, with some key markets exceeding 5%.

This implies that apartments will benefit from strengthening fundamentals since higher occupancy will not be immediately threatened by new supply in the near-term (see Exhibit 9).

 

Exhibit 9; Apartment – completions and absorption in units (thousand) – quarterly.

Ernst & Young - Commercial Property Outlook in a Rising Rate Environment

Valuations and capitalisation rates are impacted by many factors other than interest rates such as construction starts, strong economic growth, especially new job creation, mitigates the downward pressure on construction starts resulting from increased interest rates.

Developers have responded to deep demand for apartments with four consecutive years of

increasing deliveries after having slowed to a cycle low of 54,000 units in 2011. Looking ahead, demand is expected to remain positive and healthy, but new supply is gaining momentum.

Demographic trends, pent-up millennial demand and positive employment growth will

support elevated annual absorption activity over the next two years, comfortably handling new supply. Positive absorption of 141,000 units is forecast for 2015, followed by 169,600 units in 2016 and 171,700 units in 2017.

Importantly apartment completions peak in 2016, (Exhibit 10) with the vacancy running nationally at 4.3%.


Exhibit 10; Apartment completions.


Given the steadfastness of apartment demand and projections for new construction remaining somewhat contained by high construction costs, the sector should sidestep the risk of overbuilding, on average. Pent-up demand—among younger millennials in particular, could even maintain balance in markets that are at the greatest risk of overbuilding. Overall, the near-term outlook for the apartment sector remains decidedly positive.

Lending remains very attractive but it is growth has moderated.

Rising multifamily acquisitions activity has been accompanied by increasing mortgage financing. One measure of the new debt volumes is the Mortgage Bankers Association’s Quarterly Survey of Commercial/Multifamily Mortgage Bankers Originations. The Q3 2015 survey index revealed an 11% year-over-year gain in multifamily lending—a rate that, though certainly positive, is much more subdued than in the past two quarters.

Fannie Mae and Freddie Mac—the two leading sources of multifamily mortgage capital—were both extraordinarily active in H1 2015. New mortgage production moderated in Q3 2015, however, as a result of lending caps. Fannie Mae’s new business activity reached $7.3 billion in Q3 2015—down 20% from a year earlier and down 50% from the previous quarter. New mortgage production for Freddie Mac reached $10.9 billion in Q3—up 57% from a year earlier, but down 17% from Q2. Even with the more moderate volume, the agencies financed 285,000 total units in Q3, which is comparable to the entire apartment inventory of Denver in Colorado.

The slowing growth and tightening lending conditions open a range of investment opportunities for other players.

A Fed funds rate hike may not raise real estate borrowing rates substantially.

Investors face a variety of choices today when borrowing to finance their projects. Historically, much real estate debt was priced off the bank’s prime rate.

However, as the asset class has become increasingly institutionalized, real estate  loan pricing has become more dynamic, with providers of debt offering rates pegged to a variety of other observable market rates, notably 5-, 10- and 20-year Treasuries for long-term debt and the one-month London Interbank Offered Rate (LIBOR) for shorter term or construction debt. Other rates used to price commercial loans tend closely to track Treasury rates of equal maturity, so Treasury rates can be used as a surrogate for analysing movements in these rates as well.

Moreover, there has been significant growth in the availability of capital from nontraditional lenders, including hedge funds, business development companies, sovereign wealth funds, private equity debt funds, life insurance companies and mortgage REITs, as well as a host of opportunistic mezzanine lenders.

This is, in part, due to a recoiling from massive losses incurred by traditional financial institutions during the financial crisis, greater regulatory oversight and increased demand for capital to fund investments in an asset class that is becoming increasingly institutionalized on a global stage. These nonbank lenders provide a diverse array of real estate loans, which may not tie their lending rates so closely to rates in short-term markets.

Rates typically used as market indicators do not always move with the Fed funds rate.

In examining the one-month LIBOR and the 5- and 10-year Treasury rates during the period from 1982 to today, it is evident that increases in the federal funds rate do not precipitate a predictable pattern of behavior for corollary rates. Of course, this is primarily a function of duration, and it’s certainly no surprise that the one-month LIBOR most closely tracks the movement of the federal funds rate. Consequently, real estate debt priced as a floating spread over LIBOR, such as debt used for construction activity, repositioning strategies and distressed assets, will exhibit more immediate and dramatic exposure to an increase in the federal funds rate. Any downward pressure on construction activity engendered from these higher rates should help mitigate concern of an overheated real estate market because it will make it harder for new gluts of supply to outpace demand.

 

Exhibit 11: The Bank prime rate, LIBOR, and 5- and 10-Year Treasury rates have not historically moved in lock-step.


 

Predictably, the 5-year Treasury is less affected by changes in the Fed funds rate, especially in the most recent period of rising rates from May 2004 to July 2007. During that period, the Federal funds rate increased 425 bps, the 5-year Treasury rates rose by only 88 bps and the 10-year Treasury rates rose by only 6 bps (see Exhibit 11).

While monetary policy during this period is somewhat unique in that it preceded a massive financial crisis and was correctional in nature, there are reasons to believe that a federal funds rate increase today would not have a substantial effect on longer-term rates and, thus, on real estate loan rates in today’s environment. Interest rates on Treasury notes tend to be tied closely to inflation expectations over the term to maturity of the note.

However, CPI inflation for the 12 months as at November 2015 was just 0.5% which in reality is just an ebb in what has been a disinflationary trend and while the Fed predicts an upswing, inflation will likely remain tame because of a strong dollar, renewed weakness in oil and commodity prices, as well as China's devaluation of the yuan, the pace of monetary policy tightening is likely to be gradual.

Recent stock market volatility and economic weakness abroad will continue to direct capital away from riskier alternatives and toward the safe haven of US Treasury securities. But in today’s economic environment, the global demand for US Treasury securities likely is quite elastic, requiring less of a rate increase to equilibrate supply and demand.

The mechanism by which a federal funds rate hike drives up longer-term rates is simple supply and demand, which is why an increase in today’s federal funds rate may not have a substantive impact on longer-term rates. Higher short-term rates attract investors away from longer-term securities, reducing long-term security prices and increasing their yield. Federal funds rate increases today are less likely to have less of an effect on long-term rates and on real estate borrowing costs than in many previous episodes of federal funds rate increases.

Conclusion.

Recently Ernst and Young Transaction Advisory Services concluded that the Fed’s “actions and the rising interest rate’s effect on domestic real estate has been somewhat overwrought. The Fed’s initial policy adjustments likely will have only a marginal impact on CRE valuations and investment momentum”.

“Actions of the Fed to normalize interest rates should not be seen as a bane for the industry, but rather should instill confidence that their efforts are a proactive measure to provide stability in the future. On the aggregate, the lessons learned from the Great Recession, coupled with greater regulatory oversight, will temper the investment zeitgeist. This will provide a positive investment environment for US CRE.”

With vacancies trending down in apartments and increased rents, the effect of contractionary monetary policy and rising interest rates on real estate values and cap rates should be mitigated in the near term, especially for investors focused on cash flows from strengthened operations.

While many purport a negative outlook for commercial real estate based on the premise of spiking long-term interest rates, there is merit to consider the possibility that long-term interest rates will exhibit only moderate growth in the near term, given the slower pace of the US economic recovery.

Given the context of the increased capital supply and strong fundamentals in confluence with the notion that there is room yet for compression in the spread between cap rates and interest rates, real estate will persist to be an attractive investment on a risk-adjusted basis in the current environment.


 

 

Sources:

 

Ernst & Young - Commercial Property Outlook in a Rising Rate Environment

Bureau of Labor Statistics – US Department of Labor – December 15, 2015

CBRE - Positive momentum in multifamily demand endures U.S. Multifamily, Q3 2015

Federal Reserve Board members and Federal Reserve Bank presidents under their individual assessments of projected appropriate monetary policy, December 2015