The Relationship Between Inflation and Interest Rates, Briefly Explained.
- An interest rate is the cost of debt to the borrower and the lender’s rate of return; interest rates are set by lenders (usually banks) who add a premium to the interest rate, that is set by the Federal Reserve called the Federal Funds Rate(see footnote), on the money they lend to the banks.
- Low interest rates allow consumers to borrow and spend more, increasing economic activity, competition for resources, and indirectly spurring inflation.
- Higher interest rates work in the opposite direction to reduce spending and increase savings.
- Inflation is a general increase in the prices of goods and services and a subsequent decrease in the dollar’s purchasing power.
- Inflation often results when there is lots of excess money in the economy, called liquidity, competing to purchases goods and services and increasing prices; excess liquidity can be caused by very low interest rates and government stimulus.
- The Federal Reserve can impose higher interest rates to tame inflation, slowing the amount of cash flowing into the economy and incentivizing buyers to save money instead of spend it.
Inflation is expected, and the Fed targets a 2 percent average increase year over year. But beyond that percentage, economic risks swell—including runaway inflation that is known to result in a recession.
Right now, we are witnessing inflation hit its fastest growth spurt since the Great Recession in 2008. The consumer price index (CPI) in July 2021 was 5.4 percent higher than the year prior. (Inflation in the United States peaked at 13.5 percent in 1980.)
Yes, Inflation is Rising—but is it Just Rising to the Occasion?
In response to the COVID-19 pandemic and subsequent lockdowns, policymakers and central banks have introduced stimulus packages worth trillions of dollars, “printing money” to thwart a global economic crisis. Historically, these emergency fiscal policies have set a precedent for a rapid increase in the inflation rate equal to the increase in circulating money.
And, like a perfect storm, demand for goods is also up thanks to improving pandemic conditions, lifted travel restrictions, and private sector liquidity.
But supply has not yet caught up: supply chains are bottlenecking, the labor market is tight, and have you tried to rent a car lately? Plus, we are comparing current numbers to last year’s lower base prices, which was a direct effect of the lockdowns.
The Fed and many economists (Cira Capital Group included) believe that the increasing inflation rates are temporary, qualifying anything above the standard 2% increase as “purely transitional” as we return to normalcy.
Not everyone agrees. There are suspicions that inflation could stay at these elevated levels for the foreseeable and erode the dollar’s purchasing power before ultimately leading to soaring interest rates. The Federal Reserve could be pushed to raise interest rates dramatically, similar to the 1980s, in order to stop inflation.
Let’s Go Ahead and Talk About Five Reasons Why This is Not the Case.
- Rising interest rates do not directly translate to lower valuations of commercial real estate.
- Real estate has a positive, beneficial correlation to rising interest rates
- Inflation will not erode net income.
- Additionally, real estate is an inherent hedge against inflation.
- Investors can take preemptive measures to outsmart inflation and protect their portfolios.
Interest Rates and Real Estate Values.
Many opt to upgrade their housing when they have more to spend. (Not to mention how important the comforts of home and a functional home office became during the pandemic.) The same trend goes for businesses, which scale their warehouses, offices, and/or retail centers as operations grow. This demand culminates in residential and commercial rent increases across the board.
Rent increases are a real estate investor’s best friend. But they are also an indicator of inflation, which, as you know, may spur a boost in interest rates. Ok, so we’re going round and round, but what is all the commotion about?
At first glance, higher rental rates should decrease housing affordability and create a shallow pool of buyers and renters. After all, if rents increase, renters must make more income to afford the higher rent. But usually when interest rates rise, inflation, and hence wages, are rising in tandem. In addition, there is concern that higher interest rates will negatively impact the real estate operator’s net operating income, distributions of income to investors, and, ultimately, the property’s value at the time of sale.
But instead of looking at interest rates in isolation, real estate investors should examine the spread between interest rates and an asset’s capitalization rate. The two factors do not move in lockstep; therefore, rises in interest rates do not dramatically reduce prices.
Let’s Talk Cap Rates.
What is a capitalization rate? It’s a simple formula used to benchmark the income vs the value of a property: the cap rate = net income divided by the market value (or price at purchase).
Higher cap rates equal riskier—and potentially more lucrative—investments.
It represents the ROI on a property if purchased with all cash and is used as a comparison tool for investment property.
Cap rates are used in two ways:
• BUYING: Determine whether the asking price of a property is reasonable compared to other options
• SELLING: Value a property that an investor intends to sell based on comparable, close-by, and recently sold properties
Ok, now we know that real estate value is based on the amount of income the asset produces. But since real estate is often purchased with debt, the interest paid to service that debt reduces the income stream available to the investor. Any increase in debt service due to higher interest rates slashes the capitalization rate—right? No. Cap rates are measured before debt service. Why? Because different buyers utilize different types of debt, with different interest rates and amortization schedules. As a result, investors measure the net income before debt service to keep the comparison consistent.
Now, we need to talk about leverage.
But investors in real estate don’t only look at cap rates—they want to know what return on investment they can earn. And they can increase that return by using leverage.
Leverage is a financial strategy that uses debt to “lever” or increase the return on an investment. It is one of the most important concepts in real estate investing. By using debt to finance the purchase (say 70% debt and 30% cash equity) rather than all cash equity, an investor can increase their return on the cash equity they invest. Remember, cap rates are based on an all-cash purchase and income before debt service. But by using debt for the purchase of a much larger property, investors can increase the return on the 30% equity they invested.
An investor can create leverage by increasing the spread between the cap rate and the cost of debt paid to finance the purchase. The cost of debt service (the amount of annual debt service compared to the total loan amount) is the loan constant, and it is one of the most important drivers of cap rates.
The loan constant is an advanced, complex topic, but here is what you need to know for all intents and purposes: investors must be able to look at both cap rates and loan constants to determine how much leverage they can generate. Generally, a larger spread equals higher leverage. History shows that interest rates do not translate into one-for-one increases in loan constants; therefore, investors do not expect cap rates to move in tandem with interest rates either.
Why? Because loan constants are influenced by more than just interest rates. You can extend the payback period, look for a different lender with better terms, move to interest only, etc. Whatever method you may employ, they will keep the spread between interest rates and loan constants less than the interest rate’s increase.
So, it is more appropriate to examine what happens when the risk-free interest rate increases and compare that to what happens to the loan constant. Real estate investors compare the loan constant to cap rates to determine how much leverage they can generate. In addition, spreads between interest rates and cap rates are historically large and have room to absorb a good percentage of interest rate increases before cap rates jump.
What about selling the asset during times of higher interest rates?
Most investors assume the amount a buyer is willing to pay for a property will be less when interest rates are higher because more of their income will go to pay debt service. But this conclusion fails to consider increases in income due to rising rents.
Remember, real estate has a positive, beneficial correlation to rising interest rates due to inflation. So, even if the Fed does hike rates to cool a heated economy, real estate still takes a lot of wins during inflationary periods:
- Higher rents
- Increased demand
- Higher occupancy
- Lower concessions
- Less delinquency
As a result, net operating income will almost always increase. Although more income may go to pay debt service, there is more overall income, so the price a buyer is willing to pay at the time of sale may be offset by the higher income produced by the property.
Bonus: as interest rates rise, lending standards in the single-family housing market will get stricter, fewer buyers will qualify for loans, and more potential homeowners will remain renters and have to compete for rental housing. This is a plus for syndication investors as increasing numbers of renters typically push rents higher and drive increased income.
Real Estate as an Inflation Hedge.
As an investor, you have the power to protect your investment dollars by taking pragmatic, preemptive steps against inflation. Since real estate is backed by a “hard” asset that generates cash flow, it is generally viewed as frontline portfolio protection against inflationary risks. Here’s why:
Another Reason Why Inflation is a Good Thing for Real Estate Investors.
During times of inflation, it’s a good thing to be a debtor. If you borrow $500,000 today and plan to pay it back in 10 years during a period when there is a 2.5% annual inflation rate, you will still have to pay back $500,000. However, the sum you pay back in a decade will be worth 28% less due to inflation, meaning you will be paying back the equivalent of a $390,000 loan today.
In short, inflation “deflates” the value of the loan in comparison to the dollars you use to pay it back.
- If you’re a real estate investor, go ahead and breathe a sigh of relief. Inflation and interest rates do NOT erode the value of real estate. In fact, real estate is a hedge AGAINST inflation, deflates your loan value, and beyond that, it generally performs well during periods of high interest rates.
- News stories about inflation are influencing spending behavior, and a large swath of the consumer base is rushing to spend now and spend more in response, driving up demand and prices as they go. Inflation may essentially become a self-fulfilling prophecy, creating a pattern that can be hard to break.
- It would not come as a shock if inflation held steady at 3–4% in 2021 before it slopes off in the coming years as the effects of the pandemic and government spending fade. On the other hand, rent growth will likely continue to outpace inflation due to the vast housing shortages in nearly every market.
- Even with the current state of inflation, we do not predict dramatically higher interest rates. The Fed is unlikely to impose high rates due to the amount of debt the US has incurred over the last few years. To do so would be detrimental to the economy, so they will need to walk a fine line. They will likely allow inflation to run above target, but not run away, until the debt burden is deflated by inflation.
At Cira Capital Group, we help busy professionals protect their traditional investment portfolios against inflation by creating private real estate funds, pooling investors’ capital with our own, and investing with world-class operators.
Disclaimer | Past performance is not indicative of future results. |
(footnote) The federal funds rate, charged on overnight deposits, is the mechanism the Fed pulls to steer the interest rates and the economy. People often look at the treasury rate to compare rates over different time periods to get close to the risk-free rate for say, a 30-year loan.