Since the end of last year, the US Federal Reserve has initiated the tapering of its quantitative easing program, which have helped to keep interest rates at historic lows for the past several years. Most institutional investors, however, do not appear to be overly concerned about the potential impact of rising interest rates on real estate and therefore aren’t changing course in how they allocate capital to the asset class.
One investor with which PERE is familiar is a notable exception. Concerned by how core real estate may be vulnerable to rising interest rates, this limited partner (which will remain nameless by request) is planning to pull out of all of its core funds.
Factoring into the decision is the type of institution that the investor is and, consequently, the requirements to which it is subject. Still, the move is being driven by other factors that potentially affect a wide swath of investors and that most institutions should think more deeply about.
While some institutions invest in real estate primarily for diversification in their overall portfolios, others do it for return objectives. Our LP in question falls into the latter camp, having viewed its commitments to core funds – made coming out of the downturn – as a short-term tactical opportunity, not a long-term allocation. Such investments were meant to take advantage of a mismatch between the values of core real estate and the returns that those investments were anticipated to generate.
Core funds have generated double-digit returns over the last four years but, over the next two to three years, open-ended core funds are anticipated to yield returns that are closer to historical norms of 7 percent to 9 percent, according to the investor. While many investors would be happy with those returns, those yields fall below the LP’s double-digit investment return goal.
“We’re not saying that we can call the bottom, but going forward there seems to be more downside risk,” the LP said. “We thought, ‘Maybe it’s time to take our chips off the table, lock in our gains and call it a day’.”
The downside risk is that, with cap rates for institutional-quality properties at all-time lows, valuations have nowhere to go but down. According to one GP, if interest rates rise 100 to 200 basis points, property values may be reduced by 10 percent to 20 percent without significant rental growth. And if those assets are leveraged at 65 percent to 70 percent, equity values can be cut by up to half.
The math, however, isn’t as simple as that. “There isn’t a one-to-one relationship between interest rates and cap rates,” said Greg MacKinnon, director of research at the Pension Real Estate Association. Cap rates, after all, are determined by both interest rates, which are affected by Fed decisions, and growth rates in net operating income, which are influenced by the improving economy.
Indeed, the impact of a rising 10-year Treasury rate would be more of a ripple effect than a direct influence on property values. Nonetheless, that effect still points to lower valuations. When rates went up last year, long-term borrowing also rose, as did borrowing costs. If a potential buyer has to borrow more to acquire an asset, they consequently will have to buy the property at a lower price to maintain the same targeted return. But by lowering the price, the buyer effectively is raising the cap rate.
Cap rates currently maintain a 200 to 300 basis point spread over 10-year Treasuries, according to a July report from JPMorgan Asset Management. The commonly-held belief is that, with this buffer, cap rates will be able to absorb an increase in interest rates. Under the Fed’s new tapering program, however, the historically-low rates are predicted to rise to at least their normal levels of approximately 4 percent, which would imply that cap rates should be about 6 percent. Core real estate, however, currently is trading at an average 5 percent cap rate – and close to 4 percent in major gateway markets.
Another popular assumption is that rising rents from an improving economy will be sufficient to offset any increase in interest rates. “It would be great if it could be as boring as that,” the LP said. “But the markets are not like that.”
For example, after the Fed first began talking about tapering last May, the yield on the 10-year Treasury rose for the next four months, from 1.66 percent to 2.98 percent, as institutions pulled their money out of emerging markets and re-invested the capital into the US. The interrelated nature of the world’s economies therefore makes it difficult to make any neat calculations about interest rates.
To be sure, pulling out of all of one’s core funds isn’t feasible for most investors. “Typically, institutional portfolios change at a pretty slow pace,” said MacKinnon. “Dramatic change isn’t the norm.” Nor is it necessarily advisable in most cases because, even when its main investment objective is seeking returns, an institution is likely better off with a real estate portfolio that is well diversified, including by risk profile.
That said, it makes sense for many institutions to take a hard look at their core exposure. Some investors that previously made heavy allocations to core are now placing more capital in value-added opportunities and secondary markets, where returns can be generated through value creation rather than simply relying on the strength of the economy. Others might want to consider doing the same in order to exercise more control over their property investments, rather than leave them to chance in what can be an unpredictable market. While a crash in core property values isn’t necessarily likely, core real estate investing isn’t adding up to be a safe bet going forward either.
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