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TRC Blog

January 09 , 2012

What Happens to Real Estate Valuations When Interest Rates Begin to Rise?

What Happens to Real Estate Valuations When Interest Rates Begin to Rise?

by Steve Hefner | President | Connected Acquisitions. The Federal Open Market Committee has recently instituted a new version of Operation Twist, which effectively has them buying more long-term treasuries, which will continue the downward pressure on long-term interest rates. The Fed will continue to buy treasuries and has said that they will do so until 2013. Operation Twist was originally put in play in 1961 under a similar objective to lower rates back then. No meaningful changes in its monetary policy means rates will remain low for the foreseeable future. The obvious reason for doing this today is to keep the slowing U.S. economy from relapsing into recession. Indeed, the FOMC has said that the “pace of economic recovery is likely to be more modest in the near term than had been anticipated.” It restated that it will keep benchmark rates at or near zero for an “extended period,” which really is 2013, according to many on Wall Street. That might be partly because of the upcoming election, but that is a completely different story for another time. So let’s see, if the Fed does stop buying treasuries in 2013, that means two things - economic recovery and job gains. If in 2013 we have those two things, we will clearly be far from recession, double-dip recession or another prolonged stagnant period of no-growth. That’s good news for all of us, but let’s dig deeper. The government has recently bought about 70% of the treasury purchases. China accounts for the remaining 30%. Thank you China! But if the government stops its treasury-buying ponzi scheme (that’s an entirely different discussion), obviously rates will go up, a spike in bond yields will happen (investors demanding a higher return to compensate them for the risks of inflation) and the dollar will depreciate. Not so good for us as it turns out. In my view though, others will step up. Who wouldn’t want to have an ownership in one of the world’s safest investments? However, I doubt if anyone will take the 70% that the fed has been biting off. China’s 30% should continue but I doubt if they will take on more. China has a $3.2 trillion foreign exchange “desk” but it’s unlikely that it would have the firepower to continue to buy at its current pace. Ok, enough of the current economics lesson. If treasuries start to rise in 2013, that means other interest rate benchmarks rise. That further means cap rates rise, doesn’t it? If that is the case, real estate values decrease. Or do they? If you look at any chart comparing historical real estate cap rates and interest rates, the only thing you can say is that the answer is complex. First, increased interest rates in our current economy will most likely reflect improvements in the general economy and in the labor markets particularly. That means that investor’s perceptions about real estate cash flows should improve. That means property income growth should improve, so cap rates shouldn’t rise proportionally to interest rates based on this simple formula. Even if they do, they would tend to offset each other. Thus, at least real estate values wouldn’t free fall from rising interest rates. As an example, let’s say you have $1 million in NOI from an income-producing property. At an 8% cap rate, it is valued today at $12,500,000. Now, if rates increase along with investor/consumer sentiment and cap rates go up 75 basis points, don’t forget that those factors (better economy, consumer sentiment, etc.) will help your NOI, which has now theoretically gone from $1 million to $1.1 million (assume rent bumps, higher market rents and slightly higher occupancy). Cap the new NOI at 8.75% and you would have a higher valued property at $12.57 million. Not such a bad thing for interest rates to go up is it? Absolutely. Just make sure you are not “giving up the farm” in landing new tenants (i.e., giving up higher than market tenant improvements or other concessions) Key points to remember are that cap rates tend to not move with random short-term interest rate movements, but move with trend changes to interest rates. A general school of thought is that interest rates move at a 2 to 1 margin over trailing cap rates. Thus, for every 100 basis point change in interest rates, cap rates will trend 50 basis points. So, the new 8.75% cap rate above would really be about 8.375%, which translates to a new value of $13.1 million for the above property. We are in a period where we’re at the bottom of the real estate cycle and property-level incomes should be increasing. So, if you buy right and you have the right team to increase your income and NOI, a cap rate adjustment upward can be a good thing, as long as interest rates don’t hit the teens like they did in the early 80’s and I don’t think they will. The early 1980’s marked a period of the most serious economic contraction since the Great Depression until the most recent recession. Back then, the Fed established a tight monetary policy to control high inflation. Further, there were real estate tax treatments that helped investors (especially the Japanese) to pour money into real estate. The tax act of 1986 put an end to those tax savings, which put a real damper on commercial real estate. In addition, there was a huge amount of supply in all of the real estate “food groups.” We are in a much different situation today. With a world that is more closely tied to each other than ever with real time reactions, lack of information will no longer create inefficiencies in the market (like the 80’s). In the U.S., the Fed will tighten and loosen lending (among other things) to create softened peaks and valleys of economic change. For real estate, this means there is little reality of double digit lending rates anymore and thus, huge movements in real estate values. The large run up in values that ultimately collapsed in 2007 was the direct result of the collapse in the housing market, brought on by Wall Street pressures for earnings, which included the sub-prime fiasco and lenders underwriting deals that should never have been done in the first place. Mark my words, the next time a lender gives you absolutely unbelievable terms, then my advice is to take the loan, but realize that the real estate cycle is at its peak and you should be a seller, not a buyer. So, what have we learned? Slow growth is good. Real estate is recovering. Interest rates will eventually go up, but so too will tenant’s rental rates (and they will gladly pay them, as sales are increasing). Cap rates will go up, albeit not like interest rates. The result is, as long as you bought right in this recovery stage, effectively manage your properties and create NOI value, even if cap rates go up, you will still have value appreciation and sustainable, predictable current cash flows. That’s our acquisitions attitude at The Retail Connection. Deal flow is picking up and done deals will pick up in 2012. I can’t wait! Here’s to a great 2012.
2 Comments Investment 
Aditya says:
If you can buy a house then you should do so now. It is bsosiple that the price can come down more but the interest rates are going up. Start working with a reputable real estate agent /broker to see if buying a house is something you can really do now.
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