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June 2022 - Borrowing Rates & Commercial Real Estate
Our last installment of Viewpoints in March titled “How Real Estate May Serve as a Hedge Against Inflation” was a timely report on our views around current and expected inflation and how commercial real estate operates during inflationary periods. One of the points made in the last installment was that a likely response to inflation would be the Federal Reserve increasing the federal funds rate, leading to higher borrowing costs. Since then, the Federal Reserve increased the fed funds rate by 25 basis points in March and another 75 basis points in June, the largest single increase since 1994. Fed officials now forecast the federal funds rate at the end of 2022 will be between 3.25% and 3.5%, an increase of nearly 2% more than the current rate. The impact of the higher fed funds rate is already being reflected in the lending markets for commercial real estate. In this edition of Viewpoints, we share our thoughts on the impact of higher borrowing rates on private commercial real estate.
A cooling transaction market
The commercial real estate market is coming off a record year in 2021 with sales of $809 billion. This level of activity was supported by historically low interest rates and strong demand. The amount of capital focused on commercial real estate outstripped supply, leading to lower expected returns and higher valuations. But, with the March fed funds rate increase of 25 basis points, sales volume in April 2022 was 16% lower than the prior month, the first month-over-month decline in 13 months. That said, the property values were almost 18% higher than the year before.
Because cap rates have not yet responded to higher borrowing costs, in many cases leveraged buyers are accepting cash yields that are lower than the unleveraged yield, a condition known as negative leverage. Anecdotally, part of the reason values remain strong in the face of increasing borrowing costs is the large number of all-cash buyers continuing to compete for a limited set of attractive investment opportunities.
A historical perspective
Interest rates today remain at historically low levels. The 10-year Treasury rate, often a proxy of commercial real estate borrowing costs, stands at 3.2%, a significant increase but one in line with pre-pandemic levels and lower than those of the 2000’s. From this perspective, borrowing costs remain at historically attractive levels. As a result, and to the extent that real estate values respond to higher interest rates by declining, even moderately, new investments will still be able to access attractive debt financing.
An important consideration is the potential length of time an investor should expect an increasing interest rate trend. The commercial real estate market and the investment market generally have benefitted from a period of declining interest rates that began in the early 1980’s. This 40-year period is longer than but still in line with prior interest rate cycles. Since 1845, the US has been through four cycles during which interest rates increased, with a median duration of almost 14 years. The average interest rate cycle from peak to trough (and trough to peak) has lasted 25 years and with an average change in inflation-adjusted interest rates of over 12%. Considering this, the question is if the current environment in which we find ourselves is an anomaly or the norm. We would tend to err on the side of caution, believing that this time is not different. In other words, we believe we are likely in for a sustained period of rising interest rates.
Private real estate investment in an increasing interest rate environment
It stands to reason that higher borrowing costs lead to lower valuation, resulting in lower returns on portfolios of real estate assets. The logic here is the idea that real estate functions in many ways like a bond, where the price is the present value of the future cash flows. And, while that is undoubtedly true in some respects, an analysis of historical private real estate returns does not lead to this conclusion. Below are five market mechanisms impacting private real estate investments that run counter to this commonly misunderstood conclusion. Each represents a potential benefit:
Replacement Cost Effect: In our experience, commercial real estate values tend to be correlated with replacement cost. Incomes for commercial real estate assets often increase with inflation, particularly with leases tied to the Consumer Price Index (CPI), but also due to the ability to increase rents at lease expiration. The connection between value and replacement cost is due to the investor and tenant choice between buying a property or developing a new one. As replacement costs rise, due to inflation or otherwise, existing property owners can increase rents and still be a cost-effective alternative to new construction.
Portfolio Effect: A single asset will perform differently than a portfolio of assets, both because of diversification but also because a portfolio of assets is typically acquired over time, leading to different return expectations depending on the market at the time the asset is acquired. In a market where values are decreasing (i.e., expected returns are increasing in the absence of income declines), an investor can acquire assets at increasingly attractive valuations.
Debt Finance Structuring: Real estate managers actively manage debt financing to hedge against increases in rates and to protect against refinance risk at loan maturity. In an increasing interest rate environment, an active manager can lock in debt financing at attractive rates on a relative basis.
Inflation Factor: When interest rate increases are in response to inflation, it’s often the case that commercial real estate incomes are also increasing due to increasing rents. This increased income may at times offset the effect of increased expected returns (i.e., higher cap rates leading to lower values).
Real estate’s portfolio role
The role and value of private real estate as part of a portfolio is derived from its somewhat limited correlation to the equity and bond markets along with its ability to serve as a hedge against inflation. Additionally, private real estate often generates meaningful current income. With that backdrop, we feel that real estate can remain an important part of an investor’s portfolio even during times of inflation. Future installments of this Viewpoints series will touch on the opportunities and risks associated with investing in an increasing interest rate environment.
Should you have questions regarding this Viewpoints or Chestnut Funds’ approach to middle market real estate investment, please feel free to contact Steen Watson at email@example.com or (423) 822-8761.
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Cap Rate Correlation: Cap rates tend to not be closely correlated with interest rates, or at least with the rate for US Treasuries. As seen in the accompanying chart, there are times when cap rates are lower than the 10 Year Treasury rate and times where the spread is quite high. This is a result of the many factors that influence real estate values including underlying property attributes, market conditions, and the inflation outlook. Importantly, interest rates are also influenced by a host of factors like the demand for Treasury bonds as well as the shape of the yield curve.
The cause for this decline appears to be the actual, and expected, increase in borrowing costs for property acquisitions. Higher interest rates reduce expected returns and keep leveraged buyers from making competitive offers, reducing the number of prospective buyers, and limiting competition for assets. In addition to buyers getting “cold feet”, banks have also begun to tighten lending standards and, in some cases, back away from loan commitments where the property income was no longer sufficient to service higher interest rate debt. While this dynamic would tend to imply lower valuations, that adjustment has yet to occur. Instead, supply of properties available for acquisition appears to be limited relative to capital available for investment.