Interest Rates are Going Up...What Does this Mean for Real Estate?

First of all, this is just my second blog post (quick on the heels of my first). I intend this blog to be about real estate syndication but part of playing in this space is understanding the market. One of the things a syndicator does is to create a proforma (spreadsheet projecting future returns). One can not accurately predict the future, but understanding macro- and micro-economic factors that will affect your investment is a critical skill of a syndicator.

I recently read an article at Globe St. (see article, it may require a free subscription) about how rising interest rates may not affect commerical real estate cap rates. 

[NOTE: My blog will be written with a level of sophistication ideal for intermediate to advanced real estate investors, thus, I will be using industry terms such as "cap rates" without defining such terms. There are many great sources for definitions of any unknown terms or concepts that appear in my blog but Google's first hit is usually Investopedia.com which I recommend as a terrific source of info on industry terms.] 

The article quoted a TIAA-CREF Asset Management report that gave several reasons why cap rates won't necessarily increase. Most of the reasons in the Globe St. article seemed soft, not supported by strong arguments or data. I have not read the underlying report but neither did the commentators at the bottom of the article. They generally said that the article was hogwash and that cap rates MUST rise with interest rates. I beg to differ. So I spent some precious pre-holiday time formulating a response. Here is my posted comment below [NOTE: CRE is shorthand for commercial real estate]:

Cap rates are rooted in interest rates but move independently.

Fundamentally, all asset prices are a function of supply and demand. All else being equal, demand for CRE is reduced by higher interest rates. In a rising interest rate environment the risk-free rate increases and bonds are repriced. These and other higher return alternatives become more attractive. If a static pool of funds are chasing the highest risk-adjusted returns then flows increase into higher return investments thus, reducing CRE in-flows and CRE demand.

However, all else is NOT equal. In a rising rate environment, buying bonds is not automatically a great investment because, despite a higher coupon (interest payment), the value of the bond declines as higher rate bonds are issued.

The decision to raise interest rates shows that the Fed is bullish on the economy. Sectors that benefit from job growth, income growth and inflation are in higher demand. CRE is such a sector.

The pool of funds is not static. Foreign investment into US CRE has increased dramatically over the past couple of years. Private equity investment in real estate is at a new record high in 2015, up 42% over 2014 (see http://nreionline.com/finance-investment/private-e...). What is the effect of $62 billion in cash looking to be deployed into CRE? It increases CRE demand, regardless of ST or LT interest rates.

Not all funds are chasing high returns. Many (namely Chinese) are chasing an inflation hedge and capital preservation. They are looking at US CRE for stability and for its strong currency.

Thus, factors for the demand of CRE are many. If the supply of CRE (new construction, owner decisions to sell more buildings) does not increase enough to offset the additional demand, prices will continue to rise, and cap rates will go down.