Real estate investors generally acknowledge that interest rates are one of the most important economic factors to consider when monitoring the investment landscape. Interest rates impact everything else, and everything else impacts interest rates. This is a complicated topic; the best investors and economists in the world often have different views on the nuances of rates and the various forces that drive them. However, wise investors can’t put their heads in the sand and ignore this crucial component of investment analysis just because of its inherent complexity. In light of the complex economic challenges stemming from the coronavirus pandemic, now, more than ever, we must be thoughtful about these issues and attempt to develop a posture towards their impact on the marketplace. In this article, we’ll work through some of the elementary considerations for how changes in interest rates impact real estate investments.
Rents
In an environment where interest rates are increasing, it’s likely that rents are increasing as well. Inflation leads to rent growth, and this is generally thought of as a good thing for owners of real estate. Conversely, in an environment where interest rates are low, rental rates tend to stagnate. Slower economic growth leads to less ability for investors to demand higher rents, which places downward pressure on net operating income. While increases in rents are obviously helpful for real estate investors, there are other clear downsides to rising interest rates - namely, less attractive financing opportunities and lower levered yields. Additionally, it’s worth noting that, as is the case with all economic factors, there’s a chicken-and-egg dynamic at play with rents, wherein changes in rent demand can lead to changes in interest rates. Drivers for interest rate changes are both the activities of the marketplace at large as well as the interventions of central banks; to the extent that the federal reserve develops interest rate policy as a function of observations in the marketplace, changes in rent demand are a contributing factor to changes in interest rates.
Operating Expenses
Inflationary pressures leading to increased rents in a rising rate environment are also likely to be accompanied by increased operating expenses. The joys of growing rents are somewhat offset by growing expenses, but generally rent moves more quickly than do some expenses that real estate investors incur. For example, whereas rent growth is a leading economic indicator, growth in property tax burdens tends to be slower. As such, rising rates tend to coincide with improvements in net operating income, even if expenses are growing as well.
Asset Prices
It stands to reason that there should be a clear tie between rising interest rates and rising asset values. However, the inflation of asset prices -- that is, the value of stocks, bonds, real estate, and other investment assets -- differs from the inflation of the cost of goods and services, and is not necessarily correlated to changes in interest rates. For instance, interest rates have been historically low in recent years, and consumer goods inflation has been low to match this -- yet the price of assets has risen dramatically. When the cost of capital is very low, investors may be more willing to stretch to generate a return on capital, which can lead to growth in asset prices while demand for investment assets ebbs and flows as a result of a variety of economic factors; while interest rates contribute to the concoction, they are not the primary determinant of asset prices.
Borrowing Costs
Obviously, higher interest rates mean higher borrowing costs -- literally! For real estate investors, in the short term this equates to tighter deals and potential challenges to valuation. Transacting at the front end of a run up in rates can present challenges to investors, as this is often prior to increases in net operating income that would accompany the change in rates. In general, long term changes in interest rates are no issue as markets eventually achieve equilibrium. However, investors should be careful in the early days of an increased rate environment, as overleveraging at higher interest rates without commensurate increases to rents can present significant challenges.
Cap Rates
It’s the view of Birgo Capital that upward movement in cap rates to accompany long-term upward movement in interest rates is the single greatest interest-rate related risk of which real estate investors should be cognizant. Interest rates and cap rates today are at historic lows; cap rates have not yet decreased in keeping with the drop in rates, but we believe they eventually will, as has been the case abroad. However, in a scenario in which interest rates increase materially, there is a strong probability that cap rates will move upward with them. On the one hand, this is simply a concern, because, all else being equal, higher cap rates mean lower property values. However, “all else being equal” is almost certainly not going to be the case in this scenario. The accompanying economic conditions that would dictate a material rise in interest rates would generally have to be such that the economy is healthy, asset prices are high, demand for rents has been increasing, and growth in net operating income should work to counteract growth in cap rates and sustain asset prices. This rationale for the preservation of asset values in a rising rate environment notwithstanding, investors should be cognizant of potentially increased cap rates as a material risk to exit strategies and structure portfolios accordingly.
Conclusion
Attempting to anticipate what will happen to the real estate investment market if interest rates increase can be a daunting task. The myriad of economic factors that combine to determine the impact to cash flows and values can inhibit investor confidence, and ultimately result in keeping capital on the sidelines due to uncertainty. In our view, the simple exercise of thinking through what these factors are and how they are likely to impact the investor puts us in a much better position to have an understanding of risk and opportunity. There are ways in which rising interest rates would help real estate investors, and there are clear challenges that would arise from the same. Birgo Capital believes it’s the discipline of consistently thinking through those factors and reacting honestly in making investment decisions that will result in favorable outcomes.
Interested in learning more about investing in private equity real estate? Reach out to Birgo Capital's partners today.
.jpg)
