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6 Implications of Rising Interest Rates on Real Estate Investments

by Scott Smith

Rising interest rates on real estate investmentRising interest rates do not automatically result in lower real estate values or dividends. Rather, how rates affect real estate returns is complex and depends upon a myriad of factors. Property performance trends have been historically resilient during times of rising interest rates. 

Although you may expect higher interest rates to translate into higher capitalization rates and lower property values, the correlation is rough at best. Rising interest rates usually indicate that the economy is getting stronger, increasing the demand for real estate. The “relationship” is much more complex.

Because real estate values have surged since 2009, it appears we could be reaching the peak for valuation increases. Yet, experts predict that economic growth will continue to be strong. Real estate remains an attractive way to diversify a portfolio because it can often provide predictable cash flows, higher risk-adjusted returns when compared to other asset classes, and a hedge against inflation.

    1. For the remainder of 2017, the real estate industry faces uncertainty in the political arena, increases in interest rates over time, and increased property valuations. However, it is anticipated that demand for real estate will continue to increase and that the current supply and demand ratio is favorable for real estate.

    2. REITs historically perform well in rising interest rate environments and inflationary environments. During six monetary tightening cycles, REITs generated an annual return of 12.6% between 1979 and 2012. When US Treasury yields were rising, REITs generated an annual return of 10.8%.

    3.  A review of empirical evidence reveals the link between capitalization rates and interest rates is not as strong as many people think. Rather, cap rates and real estate values are more greatly tied to economic growth expectations and credit spreads relative to US Corporate bonds.

    4. REITs or other real estate investment vehicles can be an effective hedge against inflation, outperforming stocks and bonds during inflationary periods. They provide dividends that may outpace inflation in various levels of inflationary cycles. Commercial real estate owners can often pass cost increases on to tenants when interest rates on loans increase or when inflation causes increases in energy and other operating costs.

    5. Land values tend to increase over time, providing tangible asset growth independent of the interest rates. However, rates affect the cost of financing a purchase.

    6. During periods of rising US Treasury yields and tighter monetary policy, cap rates may decline and real estate values rise. The market perceives that a recovering economy will drive rent increases and higher occupancy rates.

Short-lease property sectors, such as hospitality and multifamily, perform even better than long-term lease properties when the economy does better. For example, hotels, apartment, and self-storage properties can more rapidly increase rental rates to reflect stronger economic conditions. Therefore, they can reflect revenue growth more quickly during an inflationary period than other asset classes.

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Filed Under: REITs, Real Estate