CRE Outlook in a Rising Rate Environment
Great research piece that came out back in September by Ernst & Young's Real Estate Advisory Group.
The title is "Commercial Property Outlook in a Rising Rate Environment" - very good analysis of the potential impact on CRE values due to the Fed's short term interest rate hikes.
The fervent discussion of upcoming Fed actions and the rising interest rate’s effect on domestic CRE has been somewhat overwrought. The Fed’s initial policy adjustments likely will have only a marginal impact on CRE valuations and investment momentum. A shock to the US 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. With vacancies trending down in office, retail and industrial properties and hospitality and multi- family exhibiting 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 CRE 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, CRE will persist to be an attractive investment on a risk- adjusted basis in the near-term.
However, investors should be judicious in underwriting risk as trophy assets in gateway markets appear to be fully priced with new supply coming at a faster pace. Expect to see investors looking aggressively to primary and secondary markets to find value as US CRE assets are well positioned fundamentally.
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.
This is definitely an endorsement of our strategy. We are focusing on secondary markets, and on properties that are considered "value plays" that are being acquired at higher than average cap-rates and with strong cash flows. As investment capital moves away from the higher priced "trophy properties" that are, in fact, more sensitive to rate increases, it benefit our portfolio of better yielding properties.
The entire piece - which has a number of good graphs as well - can be found here: http://www.ey.com/Publication/vwLUAssets/EY-commercial-property-outlook-in-a-rising-rate-environment/$FILE/Commercial%20property%20outlook%20in%20a%20rising%20rate%20environment.pdf