As this issue of PERE was going to press, the Federal Reserve convened in a two-day meeting to decide whether to raise its benchmark interest rate for the first time in nine years. In a heavily anticipated decision, the US central bank announced on the second day of the meeting that it would keep the federal funds rate unchanged at near zero, although the Fed still was expected to raise rates by year’s end.
In advance of the meeting, the pundits were out in full force, making predictions on the impact of a rate hike on everything from the stock market to credit cards to the price of gold to yes, the US commercial real estate market.
Indeed, at least two firms published research papers on the topic in the week leading up to the Fed meeting. In one paper, advisory and tax firm EY forecasted that a rate hike would not have a significant impact on real estate values in the short term, citing reasons that included the lack of correlation between the 10-Year Treasury and commercial real estate cap rates and an improving US economy being the basis for a Fed rate hike.
In another paper, however, alternative investment manager Deutsche Asset & Wealth Management (AWM) took a slightly more negative view, calling rising interest rates “a potential headwind” that, although unlikely to rise sharply, could dampen future capital gains. For example, the National Council of Real Estate Investment Fiduciaries Property Index is expected to generate total returns averaging 7.3 percent annually over the next five years, lower than in the past, the report said.
The two papers were the latest contributions to a debate that has raged on for more than a year about when the Fed will increase rates, and the potential impact of such a hike on commercial real estate. But at the end of the day, it doesn’t really matter what EY, Deutsche AWM or any of the other pundits think. The fact is, an interest rate increase already has been having an impact on the private equity real estate industry – even though the Fed has yet to raise rates.
The mere specter of a rate hike has stoked fears that commercial real estate values will fall when interest rates rise, based on the premise that interest rates and capitalization rates – a key real estate valuation measure – are strongly correlated and therefore mirror each other in their movements. Although the EY report dismissed such thinking as being overly simplistic, it appears that this very thinking is helping to create an investment opportunity for some private equity real estate firms: public real estate investment trusts.
Indeed, “real estate investment trusts struggled in the first half of 2015, underperforming broader equity markets as investors priced in slower economic growth and expectations of rising interest rates,” the Deutsche report said. Additionally, as interest rates rise, REITs appear less attractive relative to other investments such as bonds, whose yields increase in tandem with interest rates.
Negative investor sentiment, even if it may not necessarily be justified, is a big reason why the shares of many public REITs have been trading at significant discounts to the net asset value (NAV) of their underlying real estate assets. This discount in turn has made REITs prime takeover targets for private equity firms that, in a frothy commercial real estate market, have had difficulty finding asset-level investments that can meet their opportunistic return targets.
This year alone, private equity takeovers of public REITs have included Brookfield Asset Management’s acquisition of Associated Estate, Lone Star Funds’ purchases of Home Properties and Quintain, and The Blackstone Group’s buyout of Strategic Hotels. In fact, EY predicted more leveraged buyouts involving public REITs going private in the coming year, given the abundance of capital in the market, strong property valuations and a positive economic outlook.
And let’s keep in mind that the REIT stock devaluation – and resulting surge in takeover activity – all has been based solely on the anticipation of a rate hike. Take-private transactions, however, are likely to ratchet up considerably when the Fed actually does decide to increase the federal funds rate, since such an action would further spook investors and consequently, widen the spread between a REIT’s trading price and its NAV even more. One real estate fund manager that previously has acquired stakes in public REITs recently told PERE that his firm would seek to execute a takeover at such a time.
Of course, an interest rate hike would have a far more wide-ranging impact on private equity real estate than just an uptick in public-to-private takeovers of REITs. But this commentary is focused solely on the present-day impact of an anticipated rate increase, not the future impact of an actual one. We’ll leave the predictions to the pundits.