Commercial property outlook in a rising rate environment

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As the Federal Reserve looks to normalize monetary policy after a sustained period of exceptionally low interest rates, some commercial real estate (CRE) investors, developers and lenders are worried that CRE values will be negatively affected under the assumption that when interest rates rise, CRE values will fall. This relationship seems intuitive at first — rising benchmark interest rates, like Treasuries, should cause all yield-oriented investments to be less attractive. On closer examination, however, the relationship between interest rates and CRE values is much more nuanced. The trajectory of capitalization rates (cap rates) and real estate values is also impacted by other significant drivers like, demand and supply changes, transaction activity and trends in the overall economy.

At the broadest level, an uptick in the federal funds rate may make it more expensive to develop new projects and refinance certain debt, and possibly engender a reactionary sell-off in publicly traded real estate investment trusts (REITs). And yet, as it stands now, relative to historical averages over the last 30 years, the spread between the 10-year Treasury and CRE yields appears to allow room for further compression, and this suggests that CRE values are not immediately threatened by rising interest rates. This seems especially so as other forces buttress real estate values, like record amounts of inbound capital, available private equity “dry powder,” a generally positive economic outlook (albeit with clear caveats) and strong CRE fundamentals.

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. 

EY - Commercial property outlook in a rising rate environment

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