While conventional wisdom suggests interest rates affect real estate pricing, the concept could be misleadling, writes Matthew Mowell
In an eagerly awaited decision, the Federal Reserve kept interest rates on hold at its September 2015 meeting, showing caution in the wake of further economic weakness emanating from emerging markets. However, should the US domestic economy remain on a decent footing, a tightening cycle may commence soon. In raising rates, the Fed is certain to take a gradual approach. Elsewhere, the Bank of England is the only other major central bank adopting an even remotely hawkish tone.
Interest rates and bond prices have an inverse relationship; when interest rates rise, so do bond yields. With real estate, interest rates affect the cost of capital and the demand for investment. These capital flows influence the supply and demand for property and, as a result, affect property prices. With interest rates providing such an important basis for commercial real estate valuation, it seems intuitive that a Fed hike would affect performance – but will it?
An examination of the data suggests a weak relationship between US 10-year bond yields and real estate cap rates in the US, yielding a correlation of just 30% since 1980. The relationship is stronger in the UK, at 55%, possibly because of the way the index is constructed. Meanwhile, share prices of listed property companies have become increasingly sensitive to bond yields, more often rising as yields fall and vice versa, reaching a record correlation in 2015.
Ultimately, the link between bond yields and commercial real estate valuations is not definitive, nor is it constant. Since the early 1980s, when inflation was running at double-digit levels, interest rates have trended downward and have generally brought cap rates with them. This is the secular story but real estate is affected by idiosyncratic factors that are unique to each economic cycle, such as broader capital market trends and investment alternatives.
In the early 1980s, the consumer price index (CPI) was in double-digit territory and investors flocked to real estate for its inflation-hedging abilities. Treasury yields soared when the Fed and Bank of England raised bank lending rates to nearly 20% to stabilise prices. Meanwhile, cap-rate spreads fell into negative territory and remained there for much of the decade. Furthermore, US savings and loan banks and Japanese groups flooded the sector with easy credit and well-funded developers destabilised fundamentals. In the City of London, planning regulations were liberalised to allow for 11m sqft of new space, or 20% of existing inventory. Thus, the sector faced a perfect storm when the stock market crashed and the construction market was overwhelmed by speculative development. The situation was amplified by struggling credit markets – a condition that would haunt the sector again.
The late 1980s and early 1990s cycle was extremely painful. US valuations fell 32% cumulatively from 1990-95, according to NCREIF, as cap rates shot upward and risk premiums became important again. To put this into context, US valuations fell 31% during the recent financial crisis. This cycle would not be quickly forgotten and commercial real estate was ignored for much of this decade despite high single-digit yields. Indeed, the advent of the digital economy and roaring public equities markets hardened investors’ resolve against property. Although interest rates declined during the first half of the decade, cap rates hardly fell.
In the early 2000s, the technology bubble burst as investors grew tired of profitless firms. The Fed quickly eased interest rates to support growth, causing long-term bond yields to fall and cap rate spreads widened globally. With fewer alternatives, investors began to dip their toes back into real estate and from 2001 to 2003 the revered positive correlation between interest rates and yields worked in the asset class’s favour.
This return to real estate was also driven by stronger fundamentals, as demand-driven inflation caused rents to rise. From 2004-06, the Fed undertook a tightening cycle that represented its most aggressive tightening move in 25 years, increasing its target rate from 1% to 5.25% over a two-year period. Despite this large increase in the risk-free rate, these years also represented a rampant expansion for commercial real estate. Indeed, the listed real estate sector generated total returns of 76% versus a 14% gain for the S&P 500.
We all know how that cycle came to an end and the aggressive policy responses employed to stabilise the world’s economy. Near-zero bank rates caused yields to plummet across the spectrum and the search for return in riskier assets caused cap rates to follow suit – again reinforcing the connection between long-term bonds and commercial real estate pricing.
Given where we are today, with the Fed considering a tightening move, it is perhaps most sensible to draw parallels with 2004. Commercial real estate yields remain relatively attractive, while cap rates in the most prominent markets are at record low levels, although risk premiums are extremely wide. Policy uncertainty has increased volatility among liquid assets, but history has taught us that interest rates do not always lead commercial real estate pricing and performance.
Currently, and possibly most importantly, liquidity has improved in recent years among both equity and debt capital. Increased regulation following the global financial crisis should keep lenders from returning to the extremely lax lending practices of the previous cycle. Indeed, it is the end of the credit cycle that seems to have the most consistent impact on real estate performance – much more than subtle changes in Fed policy and interest rates.
Matthew Mowell is US analyst at Standard Life Investments
Economic Briefing: Credit trumps interest rates
- Currently reading
Economic Briefing: Credit trumps interest rates