Who’s Afraid of the Big Bad Rate Hike?

By David Blatt

David Blatt, CapStack Partners

Now that the Federal Reserve has voted to implement its first rate hike of the year, and is signaling further increases ahead, real estate investors are confronted with the reality that the historic low-rate environment they have been enjoying this past decade is slowly but surely coming to an end. In particular, investors have expressed concern over the dampening effects that rate hikes will have on real estate values. The worry is that higher interest rates directly translate into lower property prices, a market slowdown and an overall cooling effect.

However, higher rates do not spell trouble for real estate investors. On the contrary, they are a welcome sign of current and continued market strength. Some of the fundamentals driving this are a reduction in unemployment, wage growth and consumer confidence—all good things for real estate.

Most real estate investors navigate today’s market bearing the scars of the last bull run that drew us into the Great Recession. However, that was then and this is now. It’s important for real estate investors to zoom out and look back at the last few cycles to get a better handle on how the real estate capital markets have behaved.

One must also examine the impact of higher rates through market ups and downs. Doing so provides a far better perspective on where we are today and where we might be headed in this real estate bull market.

Bull & Bear Traits

Studying a decade of loan data from the FDIC and CMBS market, and equity data from the REIT markets yields three key takeaways:

1. Loan volumes neither increased nor decreased because interest rate were high or low, meaning that rates didn’t directly affect capital lent for real estate investments.

2. REIT performance also didn’t correlate to rates rising or dropping.

3. Real estate market strength tracked more closely to capital availability. Bull and bear markets were characterized more by the volume of capital flowing into the space than by borrowing costs.

Applying decades of history to today’s market, we see that loan origination volumes are fairly robust and are on the rise, and that more entrants are coming into the real estate lending space. In addition to capital from commercial banks, CMBS and life companies, billions of dollars are being committed to debt funds and nonbank lenders that are filling the financing vacuum left by banking regulation during this market cycle. More breadth of lenders and more depth of resources is good for real estate investors because it means there are more lenders competing to lend capital.

On the equity side of the equation, hundreds of billions of dollars are being allocated to U.S. real estate from both domestic and foreign sources. According to KPMG’s 2017 Real Estate Industry Outlook Survey, “A majority of real estate industry leaders…plan to increase their U.S. investments this year, as they expect continued growth in the U.S. real estate market in 2017 and beyond.”

This is largely due to improving real estate fundamentals, an increase in equity capital from investment funds and an influx of foreign players. This doesn’t take into account family offices funding direct investments. More equity groups with more capital committed to real estate means more support for higher values.

Feeling the Tailwinds

Until 2017, real estate was long part of the broader Financial Sector stock market category lumped in with banks and insurance companies. It is now its own sector in the Global Industry Classification Standard (GICS®). As a result, publicly held investors, particularly REITs, should experience capital influx and feel some tailwinds. The main factors are money managers adjusting their portfolio allocations to make room for this asset category, and the growing popularity of index investing, which offers retail investors the opportunity to access real estate via exchange-traded funds.

While interest rates certainly impact borrowing costs, an increase signals that the country’s financial health is continuing to strengthen, so it’s a good directional indicator. However, if you want to gauge the momentum of this real estate cycle, the better indicator is to follow the money flow. As long as debt and equity continue to be committed to real estate investments, broader values will hold up.

As it stands, hundreds of billions of dollars are chasing deals. Additionally, the Trump Administration is committed to loosening banking regulations that could make debt more available. Layer in the effects of tax reform, and it could add up to a surge of capital for investment. Interest rate hikes notwithstanding, this scenario signals that the real estate bull market has at least a few years of runway left.

David Blatt is CEO of CapStack Partners, a New York City-based investment banking firm specializing in the real estate, hospitality, infrastructure and energy sectors.