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Special report

Interest Rates and Their Effect on Real Estate

Dominic Toth | June 15, 2022

The macroeconomic environment is becoming increasingly complex for real estate investors to navigate. On one hand, economic data still points to fundamental strength in many sectors. On the other hand, inflation has reached record levels, prompting the Federal Reserve to aggressively raise rates. With the 10 year Treasury topping 3% in early June, the risk premium has compressed for the commercial real estate sector, potentially impacting cap rates and pricing.

Cap Rates and Interest Rates

Spreads between cap rates and the 10 year yield have historically been a strong driver of capital flows into property markets and cap rate compression.

Source: CoStar, U.S. Treasury

The risk premium, which is calculated as the cap rate less the 10 year Treasury Note yield, continued to compress across all property types.

Cap rates tend to move in the same direction as long-term interest rates but not in lockstep. They have been on a downward slope over the past two decades, mirroring the 10 year.

Despite the 10 year touching 3% in June of this year, cap rates have remained stable across all core property types as of June.  

There are simply more factors in commercial real estate than underwriting to a spread over the cost of capital. With the ability to adjust rents, the structural operating fundamentals of real estate make the asset class an attractive inflation hedge, driving transaction volume.

Investors Remain Active

Commercial real estate transactions in 2021 were up ~30% compared to 2019, the previous annual high. Transaction volume for commercial properties has remained strong so far through 2022, with a Q1 record of $125 billion in total sales volume. Despite the recent rise in the cost of capital, investors have remained active in the commercial real estate sector. Including sales in April and May, transaction volume has reached $88 billion and is on pace to be the second highest Q2 on record, just behind Q2 2021 sales volume of $114 billion.

Source: CoStar

The multifamily sector continued its strong run into Q2 but has exhibited some signs of softening. Rent growth has cooled after historically high growth rates, but demand has remained strong. Fueling demand is the recent rise in mortgage rates. In fact, about 2.6 million renter households ages 25 to 44 years old have been priced out of homebuying as mortgage rates rose from 3% to over 5%. Despite strong fundamentals for the apartment sector, increased interest rates are creating concerns about the durability of property values. With the average market cap rate at 5.1% as of June, the apartment sector had the lowest risk premium at 2.1%, down from 3.7% one year ago. While the sector does benefit from the ability to re-price their rents during inflationary periods in order to offset higher nominal interest rates, the current risk premium suggests that cap rates are likely to hold steady or expand for the apartment sector. 

Source: CoStar, U.S. Treasury

The retail sector continues to benefit from robust consumer spending, pushing many retailers to selectively expand. This is despite increasing concerns over inflation and a potential economic slowdown. Typically, consumers cut back on non-essential spending during times of uncertainty or rising inflation. Similar to the sector as a whole, retail properties that sell necessities or are anchored around grocery stores, are likely to outperform. With the average market cap rate at 6.4% as of June, the retail sector has room for further compression in cap rates. Compared to multifamily and industrial, the risk premium for retail is high at 3.8%, down from 5.4% one year ago. Still, with concerns over the economy, fundamentals are expected to soften, curtailing leasing activity, slowing rent growth, and putting upward pressure on cap rates. 

Source: CoStar, U.S. Treasury

Demand for space is weakening once again, with net absorption falling back into negative territory and the pool of available sublease space expanding. Uncertainty remains the prevailing theme, as firms continue to debate workplace schedules and assess real estate requirements. And with the risk of recession rising amid high inflation and aggressive Fed policy, a full recovery in the office market is likely a longer-term proposition. Higher interest rates, and subsequent cost of debt, could weigh on both activity and pricing going forward. However, with an average cap rate of 6.9%, the sector offers favorable yields, especially relative to other property sectors.

Source: CoStar, U.S. Treasury

Absorption of industrial space is robust, and asking rents are strong. While softened economic growth and high inflation are likely to slow consumer spending, a record amount of capital has been raised for deployment in the industrial sector. Investors remain drawn to the sector given its potential for rent growth to exceed or at least keep pace with inflation, and the uncertain long-term leasing prospects in other major real estate sectors such as office and retail. With the current spread above the historical average, industrial cap rates have room to compress further from 3.1%.

Source: CoStar, U.S. Treasury

Interest rates and the consequent cost of capital are a factor in determining the future trajectory of property values, but they are just one of many factors. While data still points to fundamental strength in the economy, there are signs of softening. The most recent Consumer Price Index (CPI) reading of 8.6% indicates inflation remains a real concern and further increases in interest rates will be needed. The rising cost of capital along with softened property performance will reduce net operating income, putting upward pressure on cap rates.

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