The Federal Reserve’s December interest rate increase was hardly a surprise to anyone in the real estate industry.
Likewise, few raised eyebrows at the three anticipated interest rate hikes forecasted for 2017. With barely-perceptible increases of 25 basis points predicted, early-winter conversations have centered more around the unknowns of a new US president than monetary policy. And for good reason: most astute real estate investors have already factored the long-term interest rate changes into asset pricing and economic outlooks, while major political changes, with all of the uncertainty that they carry, are taking time to analyze. However, rising interest rates could potentially have an impact on a range of investment strategies, some more negatively than others.
Before delving into specific strategies, it is critical to note that interest rates are not a net drag on real estate. When the Fed sets targets higher, it is because the economy is improving, and more income generation from a growing economy leads to better outlooks for all types of real estate.
For example, a stronger economy presumably would boost consumer demand, which would benefit both retail and residential properties. Some investors worry about the interplay between capitalization rates and interest rates, but research overwhelmingly shows a lack of precise correlation between the two. Changes in Treasury yields do not necessarily result in shifts in cap rates, so there can be still a comfortable spread between the two in a rising rate environment, according to a 2016 TIAA Global Real Assets research report. Of course, a host of other macro factors, from tax policy to e-commerce, as well as micro factors like local supply and demand, also play a role in driving cap rate movements.
Singling out interest rates of the many variables affecting real estate, the investment strategies with the most to lose are bond-like properties. These assets typically are occupied by tenants who have signed long-term leases with minimal, if any, rental increases built into the lease agreements.
Consequently, such properties offer less protection against both higher interest rates and inflation that typically would be offset by compounding net operating income over time in other types of properties. Multiple industry observers, for example, have cited single-tenant net lease properties as one of the biggest losers in a rising rate environment.
On the other hand, residential-focused investors can worry the least when it comes to interest rates. While many of these investors may be concerned with overbuilding in certain markets, the Fed’s movements will not impact most of their bottom lines. In fact, higher mortgage rates, which began to creep up in late 2016, will deter some would-be buyers from homeownership, leading to more rental demand. Most single-family and multifamily landlords can change rents yearly, so such increases will help absorb any higher debt costs arising from rate hikes.
For other investment strategies, the jury is still out on the impact of the forecasted rate hikes. Alternative real estate strategies could benefit from a growing economy reflected in higher interest rates. The self-storage, medical office, data centers and senior housing sectors, for example, are all driven by structural and demographic trends that bolster demand for these property types.
Such demand in turn would support any rental increases that owners would make in response to higher rates, allowing alternative real estate investors to potentially weather rate hikes better than the traditional four property types. However, it is unclear how these niche strategies – which were largely missing from institutional investors’ radar prior to the global financial crisis – will perform going forward, as they have been largely untested in a higher interest rate environment.
Yet in assessing the biggest winners and losers in the face of rising rates, one might want to look less at property type and more at the individual investment professional. Those who built their investment careers post-GFC have never known anything but historically low interest rates, after all. For those professionals, 2017 will mark a new chapter in their careers.