With both cap rates and interest rates poised to climb over the next several years, real estate returns stand to be less robust than they have been in recent years, according to a new report from Deutsche Asset & Wealth Management (DeAWM). This trend, in turn, will favor investments in certain property types for the foreseeable future.
“Factoring in modestly rising cap rates and higher interest rates, unleveraged returns to real estate will likely moderate compared to recent performance,” DeAWM’s research team, led by Mark Roberts, wrote in the firm’s 2014 US mid-year review. The NCREIF Property Index is expected to generate total returns in the 7.5 percent range from 2015 to 2019. By comparison, NPI returns for the last four quarters averaged 11.21 percent.
Returns in the recent past had been fueled by strong capital appreciation from cap rate compression, which has occurred partly because of the ongoing contraction in the 10-year Treasury rate, which fell 30 basis points to 2.6 percent during the year. However, with cap rates at or near a low point, returns going forward are likely to be more heavily based on rising net operating income and overall will be lower, the firm said. Meanwhile, rates are expected to begin rising over the next five years and likely within the next two years.
Cap rates for suburban office, flex, warehouses, retail centers and high-rise apartments have all declined between 30 basis points and 75 basis points since 2011. Cap rates continued to drop during the first six months of this year, although the decline stabilized during the second quarter. Over the last six months, warehouse and flex properties saw the biggest drop in cap rates, while rates for high-rise apartments held steady.
Meanwhile, interest rates likely will rise over the next five years, but the impact of higher rates depends on the factors behind the increase. If the rate hikes are the result of an expanding economy, cap rates would likely remain flat and the spread between cap rates and interest rates would remain narrow because the increasing rates would have a positive impact on property fundamentals, the report explained.
However, if the rate increases are caused by economic woes, then cap rates may rise more quickly than interest rates. Because of this, DeAWM recommended that investors reduce exposure to properties that have longer leases and therefore limited ability to re-let space at higher rents since such properties would be most vulnerable to rising cap rates.