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Rise and Fall: How Interest Rates Impact Real Estate Values

Rise and Fall: How Interest Rates Impact Real Estate Values

It’s no secret real estate property values have benefitted from capitalization rate (cap rate) compression, due at least in part to declining interest rates. But investors worry that historically low interest rates could soon be a rearview mirror reality, leading to cap rate expansion. While forecasting future interest rate movement is tough, it is crystal clear that real estate returns moving forward will be much more reliant on improving fundamentals rather than further cap rate compression.

For multifamily, an early recovery sector, some folks worry that in addition to potentially unfavorable cap rate movement there could be another whammy around the corner — namely, slower NOI growth resulting from any future slowdown in rent growth. However, even with new completions rising, the national occupancy rate remained strong at 95.6% as of Q2 2014. So the overall U.S. market remains full, and pricing power remains with operators. In fact, since dipping to below 3% in 2013, annual rent growth among the MPF Research top 100 U.S. metros has actually reaccelerated (see Exhibit 1). While this may sound good on the surface, let’s dive into the question of “what if”.

Exhibit 1
rent_change

The biggest uncertainty facing investors is where interest rates will be in the future. Over the next several years, projections for the 10-year U.S. Treasury range from 2.5-5.0%, according to leading economists. Higher interest rates would eventually push the cost of debt higher, increasing the risk of cap rate expansion and lower property values. MPF Research looked at various scenarios to determine the pace of NOI growth needed in order to maintain values in response to a hypothetical 1% upward movement in cap rates.

The analysis in Exhibit 2 assumes an unlevered, stabilized asset.

Exhibit 2 Annual NOI Growth Rate verse Capitalization Rate

annual_noi

Next, let’s compare Exhibit 2 to the performance of the largest publically traded multifamily REITs. On average, NOI increased by 4.3% from 2nd quarter 2013 to 2nd quarter 2014, which was in line with the average full-year 2014 guidance. However, it should be noted that 4.3% was meaningfully lower than the 5.8% hike seen in the year-earlier period. Regardless of the slowdown, NOI growth remains healthy. Therefore, it seems logical to assume that over time, potential value declines would most likely be modest in response to a 1% upward movement in cap rates, given positive, sustainable fundamentals and ample amounts of capital flowing into multifamily assets. In other words, slow and steady wins the race.

Where do we go from here?

The takeaway is this: Opportunities continue to exist in the multifamily sector. NOI growth slows, but should remain solid, driven by healthy gains in rental rates. To put this expectation in the context of current trends in the marketplace, rents climbed 3.5% in the year-ending Q2 2014.

Furthermore, higher interest rates could certainly coincide with a stronger economy and an improving labor market, which could spur further apartment demand. And, if employment growth continues to improve and household formation accelerates, property values – especially trophy assets – may still have room for further appreciation – albeit, at a slower pace than the past several years.

(Image source: Shutterstock)

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