Economy Watch: Higher Rates Won’t Necessarily Drag CRE Values Down

The relationship between interest rates and property values is more complex, and likely depends more on economic growth, according to a recent TH Real Estate report.
Thomas Park, Senior Director, Research & Strategy, Americas, TH Real Estate
Thomas Park, Senior Director, Research & Strategy, Americas, TH Real Estate

There isn’t necessarily an automatic link between rising interest rates and upward pressure on cap rates, with a concurrent lower valuation for commercial property, according to a recent report by TH Real Estate—timely, considering that interest rates are on their way up. “A variety of factors are likely to mitigate the potential impact of rising interest rates on commercial real estate values and total returns,” the report noted.

That’s because the relationship between interest rates and property values is complex and likely to depend more on economic growth and real estate fundamentals, such as NOI growth. Overall, U.S. real estate total returns are expected to decline in 2017 and 2018, the report predicted, with lower capital appreciation due to the valuation surge since 2009, along with the late stage of the real estate cycle. Property values don’t depend as much on interest rates, which are only gradually rising anyway.

“Interest rates and capitalization rates are believed to move in lockstep, with higher interest rates quickly translating into higher capitalization rates and lower property values. However, that is not necessarily the case. If interest rates are rising because of stronger economic growth, as is currently the case, real estate demand will also likely be growing. If interest rates are increasing gradually, and are likely to remain at, or below, long-term averages, as is currently expected, real estate would likely be well positioned to benefit in such an environment,” noted Thomas Park, Senior Director, Research & Strategy, Americas, TH Real Estate

Common underwriting practices should also help to mitigate investor concerns, noted the report. Property cash flow valuations often assume cap rate increases of 50 to 100 basis points during the expected holding period. That reflects the aging of the property, plus uncertainty about future economic and real estate market conditions. As a result, cap rate increases are typically accounted for in return expectations, which avoids some of the potential surprise associated with them.

The timing of cap rate changes also matters. “In the near term, cap rate increases can have a measurable impact on property performance as appraisers incorporate new assumptions into their valuation models,” the report explained. “However, real estate performance is less sensitive to cap rate changes as the investment horizon lengthens. Time has the potential to heal most, but not all, wounds from rising cap rates through compounding annual NOI growth; the stronger the growth, the greater the protection.”