Real Estate in a Rising Interest Rate Environment

• Real estate can play an important role in diversified portfolios by acting as a hedge against rising prices.
• However, like other income producing asset classes, rising interest rates can put downward pressure on real estate valuations.
• Can real estate offer investors inflation protection if the Federal Reserve continues to raise rates to combat higher prices?

Background

Real estate historically acts as a strong hedge against inflation, as higher replacement costs can push asset values higher. During periods of economic growth, property owners in sectors with pricing power may also increase rents, which can grow net operating income (NOI). However, similar to other income producing investments, rising interest rates pose a threat to real estate prices as investors evaluate the relative value of real estate to other asset classes. How much of an impact can rising interest rates have on real estate values and what can investors do to mitigate those risks?

Impact of Rising Rates on Real Estate Values

The capitalization rate (cap rate) in real estate investing is the unlevered rate of return on an asset based on its annual NOI and is widely used in determining the value of a property.

Similar to the earnings yield of a stock or bond, the lower the cap rate, the higher the valuation. While the correlation between the 10- year UST and cap rates is imperfect, the two tend to move in the same direction over time, meaning higher interest rates can lead to lower real estate prices. All else equal, a 50 bps increase in cap rates equates to roughly an 11% drop in the value of a property. However, higher NOI can counteract the negative valuation impacts of higher cap rates as a higher numerator can offset a higher denominator in the formula above. The most important factors that influence NOI growth include tenant demand, lease term duration, and expense control. Generally speaking, properties with high demand relative to supply, short lease terms, and minimal operating expenses and capital expenditures tend to have the highest NOI growth potential.

Cap Rate Spreads

The spread between cap rates and interest rates is often used to determine relative value. Generally speaking, when spreads tighten, real estate becomes less attractive. However, economic conditions and real estate fundamentals tend to influence spreads more than changing interest rates. If economic growth is strong and unemployment is low, real estate owners typically maintain enough pricing power to raise rents, which helps offset the negative impact of higher rates. The same is true when the rental demand for an asset is higher than supply. The prospect of higher income growth can help justify lower spreads, even when interest rates are rising. This makes asset selection increasingly important when investing in a rising rate environment.

Real Estate Performance During Rising Rates

During the last eight rate hike cycles since 1985, cap rates have compressed the same number of times that they have expanded. The only rising rate period where core real estate delivered a negative return was during the Global Financial Crisis when cap rates expanded and low tenant demand led to negative NOI growth. Even when cap rates rise, strong NOI growth can counteract negative valuation adjustments, leading to positive real estate performance.

Conclusion

While rising rates can have a negative impact on real estate valuations through cap rate expansion, economic fundamentals tend to be the most important factor influencing real estate pricing over time. NOI growth is required to offset the adverse effects of higher cap rates, and favorable supply/demand dynamics can create the necessary pricing power for real estate owners to increase rents as interest rates rise. Property type and asset selection become increasingly important as properties with long-dated lease terms without sufficient rent escalations will be more exposed to duration in a rising rate environment, making them less attractive as a hedge against inflation.