Prudent Growth Partners, LLC  (2017)    1829 E. Franklin St, Suite 800-F, Chapel Hill, NC 27514  (919) 590-4119

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Thoughts on Interest Rates

September 17, 2015

 

As I write this everyone is still waiting to see what the Fed does later this afternoon with respect to a September interest rate “hike” – if a quarter-point, one-and-done increase can really be called a “hike”.

 

But, regardless of what happens today, a rate increase of some sort will certainly happen at some point in the next 12 months.  What might the impact be on commercial real estate – especially the sorts of assets like those owned and managed by PGP?

 

CoStar just put out this opinion piece, and I think it is a good one.  A few points from the article:

 

However, according to a new report issued this week by accounting firm EY, the relationship between interest rates and CRE values is much more nuanced. While the Fed’s initial policy adjustments likely will have a marginal impact on CRE valuations and investment momentum, interest rates and cap rates aren’t always correlated, the EY report authors claim. 

Several factors affect the trajectory of capitalization rates and real estate values, such as demand and supply changes, transaction activity and trends in the overall economy. And in the current market, CRE fundamentals are strong. 

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

However, as it currently stands, relative to historical averages over the last 30 years, the spread between the 10-year Treasury and CRE yields appears to allow for further compression. This suggests that CRE values are not immediately threatened by rising interest rates, EY said.

 

A shock to the U.S. CRE investment environment from a 25 to 50 bps increase in the overnight lending rate seems unlikely in light of the forecasted environment for the sector, according to EY. With vacancies trending down in office, retail and industrial properties and hospitality and multifamily exhibiting increased rents, the report's authors expect the effect of contractionary monetary policy and rising interest rates on real estate values and cap rates to be mitigated in the near term, especially for investors focused on cash flows from higher lease rates and strengthened property operations. 

While many observers purport a negative outlook for CRE based on the premise of a spike in long-term interest rates, the possibility that long-term interest rates will see only moderate increase over the near term is more likely given the slower pace of the U.S. economic recovery, the EY analysts said. 

They also expect CRE will continue to be an attractive investment on a risk-adjusted basis in the near-term, given current conditions of increased capital supply and strong fundamentals, along with room for compression in the spread between cap rates and interest rates, according to the report. 

Finally, the EY report authors urged investors to see the glass as half-full rather than half-empty. 

"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," the EY report concluded.  

 

Full article here:  http://www.costar.com/News/Article/EY-Interest-Rates-and-Cap-Rates-Arent-Always-Correlated/175414

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