• Interest rates influence real estate values, but not as directly as most are led to believe.
• Instead of looking at interest rates in isolation, real estate investors should examine the spread between interest rates and the asset’s rate of return, or it’s capitalization rate.
• Real estate often benefits from a well-performing economy via rising rents, increased demand, higher occupancy, lower concessions, and less delinquency.
The state of the economy is a hot-button topic right now. And real estate investors have a lot of follow-up questions. We wanted to answer some of them here, specifically regarding inflation’s effect on interest rates and how they affect the value of real estate assets.
To recap what you may already know, real estate value is based on the amount of income the asset produces. Since real estate is often purchased with debt, the interest paid to service that debt reduces the income stream. Any increase in debt service due to higher interest rates decreases the amount of income the buyer will earn as part of their return on investment.
Therefore, it’s natural to think that the amount a buyer is willing to pay for a property will be less when more income is going to pay debt service. But this is a quick jump to an incomplete conclusion, one that fails to consider increases in income due to rising rents.
Instead of looking at interest rates in isolation, real estate investors should examine the spread between interest rates and the asset’s rate of return, or its capitalization rate. The two factors do not move in lock step; therefore, rises in interest rates do not dramatically reduce prices.
Capitalization Rate = net operating income/current market value or purchase price
Q: Why are interest rates rising?
A: When an economy is hot, consumers tend to have more income and can spend more on goods and services. This leads to price hikes, also known as inflation. To tame inflation, the Fed increases the interest rate, incentivizing saving and decreasing the amount of money available to spend on goods and services.
Q: What does that have to do with real estate?
A: When consumers have extra money, many elect to upgrade their housing. We watch a similar story unfold amongst businesses with the expansion of warehouses, offices, or retail centers. Together, this culminates in residential and commercial rent increases, which contribute to inflation.
Q: Why are investors waiting for the other shoe to drop?
A: There is concern that higher interest rates will negatively impact net operating income, distributions of income to investors, and, ultimately, the property’s value at time of sale. Most believe that capitalization rates will jump if interest rates do, but it’s unlikely that we will see a one-for-one increase.
Q: When interest rates rise, does that impact real estate value?
A: In short, yes.
To clarify, we cannot take that last ‘yes’ at face value. Remember, we have to look at the complete picture, one that shows the spread between interest rates and the asset’s rate of return.
Real estate often benefits from a well-performing economy via rising rents, increased demand, higher occupancy, lower concessions, and less delinquency. As a result, net operating income increases. Although more income may go to pay debt service, there is more overall income, and the price a buyer is willing to pay at time of sale may be offset by the higher income produced by the property.
Q: What does the future hold?
A: 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.