Interest Rates and Real Estate – Q4 2014

The Federal Reserve used to be almost entirely focused on reducing inflation. Recently, however, it seems to be paying more attention to unemployment – and in keeping interest rates low to support job growth. What does this mean for real estate investors?

Stimulus is Ending, but the Fed is Still Cautious

The Fed has kept interest rates near zero for more than five years, and faces ever louder calls to increase rates. At its recent Jackson Hole conference, though, Fed Chair Janet Yellen argued that central bankers should make a trade off – accept a transitory period of inflation in order to bring the broader measure of underemployment to normal levels more quickly, consistent with achieving the Fed’s dual mandate of full employment and price stability. Other officials, including European Central Bank President Mario Draghi, also argued for continued monetary stimulus.

The Fed is still on track to raise interest rates sometime in 2015, but some wonder whether it is moving too slowly. The dragged-out process has led some to believe that investors are “reaching for yield in many ways and in very large magnitudes.” Advocates of faster action worry that rates left near zero for too long will cause inflation to accelerate. Yet inflation remains below the 2% target rate of Britain and America’s central banks, there is seemingly no pressure on wages, and the price picture also seems benign. And while there are some signs of froth – London’s house prices have surged by 10% in the past year – the excesses still seem small compared with those that brought down the global economy in 2007.

Ms. Yellen and others have argued that interest rates are too much of a blunt instrument with which to treat financial excess – and that this danger can be dealt with by using “macroprudential” tools, such as limiting loan-to-value and debt-to-income ratios with mortgages. Banks can also be forced to hold more capital and liquidity against risky loans.

How Might Real Estate be Affected by Higher Interest Rates?

What does this mean for real estate investors? Aren’t lower rates better for real estate prices, and higher rates worse?

The relationship doesn’t appear to be that simple. If the economy is doing well and incomes are going up, people can afford more and they’re willing to take a bigger mortgage. “Intuitively, you’d think that if interest rates go up, [then] house prices go down. But they don’t,” said Mark Palim, vice president for applied economic and housing research for Fannie Mae. Values might still go up, even if interest rates increase – although some would argue that increased interest rates will lead to higher expenses, and thus lower net operating incomes (and thus lower rates of return). In commercial real estate, too, sources such as Morgan Stanley caution that there are a lot of other variables besides just a singular focus on the connection between interest rates and cap rates.

Over the long term, the key question is: “Where do current real estate returns sit relative to a long-term equilibrium estimate of where those returns are likely to end up? Current 10-yr Treasury bill rates are about 2.25%, and J.P. Morgan estimates that the 10-year Treasury yield will ultimately settle in at 4.5-5.0%over the next five years. If you assume that the real estate risk premium is about 200-300 basis points, then this means that core real estate total unlevered returns should end up somewhere between 6.5% and 8.0%. According to J.P Morgan, this means that today’s pricing might well be sustainable.

The key question might be phrased as “If today’s average core buyer sold in five years, at which Treasury yields had risen to 4.5% to 5.0%, would the next buyer require a higher return to be consistent with log-term premiums? The answer generally appears to be “no,” unless Treasury rates rise to much higher than 5.0%. In J.P. Morgan’s analysis, a 5.0% Treasury world is very tight, but a 4.0% world would leave real estate still looking very attractive on a relative return basis.

All this depends, of course, on exit cap rate assumptions and other factors. Most companies doing proper underwriting are careful to model in higher exit cap rate assumptions. Those models generally allow for a bit of “cushion,” and assume that sales will be in a higher interest rate environment. The J.P. Morgan analysis of exit cap rate assumptions in several real estate funds, covering a spectrum of property classes, came to the conclusion that cushions in today’s values may be even wider than the assumption of higher exit cap rates suggest.

Other studies have shown that factors that have historically affected real estate cap rates include credit availability, the supply-demand dynamic, and inflation. In sum, then, the connection between cap rates and interest rates has historically been loose.

In the end, then, as long as a decent “spread” exists between core real estate total unlevered returns to bonds and debt, current return rates may well be very supportable with a 10-yr T-bill that settles into the low 4% range. Things may start to look very tight, though, if those T-bills get closer to 5.0%, and above that things may turn perilous. One thing will be clear in any case: as interest rates begin to rise, underperforming and overpriced assets will start to be exposed.