Some commercial real estate (CRE) investors fear that rising interest rates will cause property values to fall and sales to slow. Rising interest rates do make borrowing more expensive for purchasers, which could affect the commercial real estate market.

However, historical data shows that the interest rate impact on real estate does not necessarily impact property values, even when rates go higher.

The Relationship Between Interest Rates And Property Values Is Complex

It’s easy to make false assumptions about the interest rate impact of real estate unless you get the data first. Commercial real estate prices respond more to strong economic growth than rising interest rates. The historical statistics bear out the truth about CRE and interest rates:

When the Fed raises interest rates because of strong economic growth, commercial real estate markets stay strong.

The Proof

Between 1987 and 2018, commercial real estate prices appreciated significantly during eight periods when the 10-year treasury yield increased by over 100 basis points:

  • January 1987 to October 1987:
    NOI increased 1.4 percent.
    Total returns increased 12.8 percent.
  • November 1989 to September:
    NOI increased 1.1 percent.
    Total returns increased 2.0 percent.
  • October 1993 to December:
    NOI increased 4.6 percent.
    Total returns increased 14.1 percent.
  • December 1995 to April 1997:
    NOI increased 3.5 percent.
    Total returns increased 36.3 percent.
  • October 1998 to January 2000:
    NOI increased 5.6 percent.
    Total returns increased 28.0 percent.
  • March 2003 to June 2006:
    NOI increased 1.2 percent.
    Total returns increased 85.8 percent.
  • December 2008 to April 2010:
    NOI increased 2.0 percent.
    Total returns increased 1.0 percent.
  • July 2012 to December 2013:
    NOI increased 4.6 percent.
    Total returns increased 27.3 percent.

NOI equals a property’s net operating income. As the CRE market rises, NOI increases due to rising rents, which, in turn, increase property values. Real estate investors who played their cards right got much richer in all of these time periods because they understood the true interest rate impact on real estate.

The Interest Rate-Cap Rate Lockstep Myth

The cap rate ratio measures a property’s NOI against its market value. A rising cap rate indicates a decline in profitability. Commercial real estate investors want a higher return, which means the cap rate, or percentage of invested dollars to gain, must decline. Cap rates are extremely sensitive.

Often, investors wrongly assume rising interest rates result in rising cap rates. As the above figures demonstrate, this assumption is a dangerous misunderstanding of CRE and interest rates.

  • Interest rates and cap rates show a stronger correlation over long time periods.
  • The correlation is less during periods of large rate hikes.
  • The correlation between cap rates and the U.S. 10-year Treasury yield is moderate, at 0.58.

A wide variety of factors affect cap rates, such as:

  • Real estate fundamentals.
  • Capital flows.
  • Investor risk appetites.

In a strong economy, these factors all work in favor of the CRE market.

Federal Reserve Monetary Policy, Tightening And Rate Increases that Began in Late 2015, Is Accelerating

The Fed raises rates slowly in order to protect economic growth. Were the Fed to act too quickly in an environment of rising interest rates, the economy would suffer and possibly bring about the rising cap rates CRE investors fear.

Thus far, the Fed has done a superb job of striking the right balance. Fed Chairman Jerome Powell pledges to continue the moderate pace.

  • The Fed raises rates in 0.25 percent increments.
  • Two rate hikes are likely in 2019.

The real estate market is healthy and expected to generate moderate rental growth in most metropolitan markets across most property types. Commercial real estate analysts expect continued growth in 2019, with the impact of interest rate on real estate remaining positive.

Drivers of this growth include the overall economic boom across the country and lower taxes. In a report, The Nuveen Group predicts the following for 2019:

  • An income increase of 4.75 percent.
  • Appreciation of .05 percent.
  • Total returns to average 5.25 percent.

The Fed interest rate hikes, however slow they have been, suggest that the economic recovery no longer needs to be supported by artificially low rates. CRE and interest rates rise together in strong economies.

The Fed’s policy of quantitative easing (QE) was a successful experiment in restoring the economy after the 2008 crisis. Today’s sustained growth shows that the policy worked. The economy has grown strong enough to stand without the support of QE, which is good news for both CRE and real estate.

CRE is a great place to be in 2019, especially in the greater Phoenix area. Population growth creates demand for more apartment complexes, industrial space, warehouses and office space. LCI Realty understands where the commercial real estate sun shines brightest in the Valley of the Sun. Contact the LCI team to find your sunny spot.

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