Monday
September 1, 2014

No Cause for Alarm

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No Cause for Alarm

Cassidy Turley’s Chief Economist Kevin J. Thorpe explains why neither rising interest rates nor the tapering of the government’s quantitative easing are significant threats to the economy or commercial real estate.

Are you concerned that the Fed’s announced plan to taper its bond-buying program this year will have a negative effect on the economy and commercial real estate?

Not really. The Fed has indicated that it will slow the quantitative easing program only if the economic outlook continues to brighten. So if the Fed begins to pull back, it will be a very good sign that the U.S. economy and commercial real estate are strengthening. At this stage in the cycle, I would be more concerned if the Fed wasn’t considering tapering [the program], because that would suggest that the Fed had observed underlying weakness. But it’s the exact opposite.

Do you think that commercial properties will lose value as higher interest rates push cap rates up?

The relationship between cap rates and interest rates is overstated. Interest rates are just one aspect of the larger equation that drives property values. Other factors—debt availability, strengthening rents and occupancies, and a greater risk appetite for real estate—also have an effect. If all these factors continue to head in the right direction, then real estate values are likely to rise, even in a climbing interest rate environment.

Recent history provides a good illustration. We have had record low interest rates for the bulk of the recovery, but that did not translate into widespread cap-rate compression because property fundamentals were weak. Now that fundamentals are strengthening, that will largely trump any rise in interest rates, as long as the rise is gradual.

Are there any exceptions to this scenario?

Yes. Buildings with long-term leases in place face more downside risk from rising interest rates. These buildings, which behave more like Treasuries, were the asset class that everyone wanted to buy a couple of years ago, because they provide a stable cash flow. However, if rent inflation heats up, these buildings will have more difficulty increasing net operating income because of their long-term leases. Still, the market demand for these properties and land prices may help preserve their value.

How will rising interest rates affect borrowing for CRE purchases and development? The most likely scenario is that rates will continue to rise gradually into the foreseeable future. So the rate today will probably be lower than the rate one year from now. That creates some urgency for borrowers to act soon, but that’s easier said than done. Lenders remain extremely cautious.

How do you expect interest rates to perform over the next 12 to 18 months?

I expect interest rates to rise gradually with the 10-year Treasury yield, reaching 3.7 percent by the end of 2014 and 4.7 percent by the end of 2015. That may sound like a shocking increase, but remember that before this recession, 4 percent to 5 percent interest rates were the norm. As long as the rate increases are gradual, the market will be able to digest them.

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