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THINK US: The impact of rising interest rates on commercial real estate

THINK US - impact of rising interest rates

With prevailing sentiment that the US Federal Open Market Committee will raise short-term interest rates on Wednesday 15 March (the Fed’s third 0.25% rate hike since December 2015 and the first of three expected in 2017), real estate investors may question whether higher rates could undermine property values and operating income by raising discount rates and slowing the economy. In particular, concerns are rooted in the assumption that rising rates mean higher cap rates, which in turn can weaken property values and commercial real estate (CRE) investment performance.

However, our latest research report examines historical returns which show that rising interest rates have not automatically resulted in lower real estate values or total returns. The relationship between rates and CRE returns is more complicated and depends on a range of factors, such as the economic environment. For example, data included in the report shows a very low correlation of 0.08, indicating the absence of a relationship, between 10-year treasury yields and property value growth in periods of rising rates. The capital appreciation component of the NCREIF Property Index (a common benchmark for institutional-quality commercial real estate) is the return component most sensitive to interest rate changes.

In addition, the lack of a relationship is demonstrated by the two most recent periods of rising treasury yields. Between Q1 2003 and Q2 2006, when yields rose from just under 4% to just under 5%, total returns averaged 15.4%, including 7.8% capital appreciation. In a similar period between Q4 1998 and Q1 2001, when yields rose from 4.66% to 6.47%, total returns averaged 11.7% including 3.1% capital appreciation.

"Interest rates and capitalisation rates are believed to move in lockstep, with higher interest rates quickly translating into higher capitalisation rates and lower property values. However, that is not necessarily the case. If interest rates are rising because of stronger economic growth, as is currently the case, real estate demand will also likely be growing. If interest rates are increasing gradually, and are likely to remain at, or below, long-term averages, as is currently expected, real estate would likely be well positioned to benefit in such an environment." said Melissa Reagen, Head of Research, Americas, TH Real Estate.

Our report concludes that the relationship between interest rates and property values is complex and likely to depend more on prospects for economic growth and real estate fundamentals, such as Net Operating Income (NOI) growth. Real estate total returns are expected to decline in 2017 and 2018, with lower capital appreciation due to the valuation surge since 2009, and late stage of the real estate cycle. With forecasts for stronger economic growth and rising inflation, real estate should remain attractive as a source of portfolio diversification, stable cash flows, higher risk-adjusted returns relative to other asset classes, and inflation hedging.

"Political change, rising interest rates, and elevated valuations are just some of the headwinds facing the real estate industry in 2017. Hopefully, interest rates will increase gradually, providing the market with time to adapt. Real estate’s sensitivity to interest rate movements will be tempered by NOI growth from stronger tenant demand and favourable supply/demand fundamentals." added Chris McGibbon, Head of Americas, TH Real Estate.

Read the full report here  THINK US - The impact of rising interest rates on CRE

Issued by Henderson Real Estate Asset Management Limited, 201 Bishopsgate, EC2M 3BN. Authorised and regulated by the Financial Conduct Authority. TH Real Estate is a name under which Henderson Real Estate Asset Management Limited provides investment products and services. COMP201700172

Melissa Reagen

Melissa Reagen

Head of Research, Americas

Melissa's biography