Rising interest rates would have some impact on the real estate market, but I think the fundamentals are the key factors that investors shall be keeping an eye on, particularly the impact that evolving business models may have on the real estate sector, such as Airbnb on hotels, e-commerce on retail, WeWork on offices, etc.
At what point would rising interest rates start to dampen the U.S. commercial real estate market?
As a player on the U.S. commercial real estate market, we are looking at a couple of opportunities. We understand that the Federal Reserve will likely raise interest rates slightly next month. We do not believe that this increase will dampen the market, but at some point rising interest rates will certainly impact the market. What is that point and when might it occur? Is it safe to assume that the Federal Reserve will not want to significantly outpace Europe and Japan with regards to raising interest rates?
U.S. interest rates will continue to rise. Furthermore, the current administration has limited interest with regards to outpacing Japan or Europe based on what we are seeing with trade relations between the U.S. and China. Within the next 12 to 18 months, the interest rates will increase further than where they are now and likely impact the economics of your transaction.
While there is no question that, at some point, rising interest rates will affect the real estate market, no one is certain exactly where the tipping point will be. For real estate, long-term interest rates have a much stronger correlation on short-term rates, so increases by the Fed in short-term rates will not have a direct, profound impact on real estate values or the market unless it spills over into long-term rates. The best yardstick would be the 10-year treasury rate. Most experts expect short-term rates to increase by 200 bps, plus or minus, and it is expected that an increase in rates to that extent that “normalizes” interest rates after a prolonged period of artificially controlled short-term rates would, in and of itself, have only a minor impact on the market. However, if long-term rates experience a similar increase and the result is not merely a steepening of the interest rate curve of 200 bps or more, then most experts expect this would have a significant impact on values, causing some cap rate increase and more challenging lender underwriting on debt yield and other metrics. Thus, while one can expect increases in short-term rates to continue gradually for some time, if the result is just a steepening interest rate curve without a corresponding increase in 10-year t-bill rates, real estate should not be impacted materially. If the increases in short-term rates do not keep inflation under control and moderate economic expansion, and long-term rates respond by increasing by more than 200 bps, then we could be in for a hard landing and some distress in the RE sector, especially when loans made in low rate environments mature between 2020 and 2023.