Will Rising Interest Rates Pummel Your Portfolio?

• Rising interest rates can lead to rising capitalization rates, depressing the value of real estate assets.
• Since 2008, global monetary policy has produced negative real interest rates, boosting the value of real estate assets.
• As interest rates increase, real estate valuations in some markets could take a hit.
• Economic growth should improve real estate fundamentals, favoring cap rate spread compression, especially in the United States.
• Excess capital from China and other countries is expected to bolster real estate valuations in prime markets.

Interest rates have nowhere to go but up—but when that happens, capitalization rates can follow. Barring other factors, real estate valuations could decrease significantly. But will that really happen?

A speed-learning session at the 2013 ULI Fall Meeting explored answers to this question with Richard Barkham, Grosvenor’s global research director, who provided a global outlook, and Eileen Marrinan, Grosvenor Americas director of research, whose presentation focused on the United States.

Barkham noted that in the wake of the recent financial crisis, the world’s key central banks have undertaken aggressive quantitative easing. Since 2008, global monetary stimulus has produced negative real interest rates, boosting the value of real estate assets while also generating moderate economic growth. As a result, prime cap rates are extremely low.

Barkham asserted that while rental pressure depresses cap rates, the more significant driver of cap rates is bond rates, which already have started to trend upward. His latest model predicts that a 100-basis-point change in bond rates leads to a 62-basis-point change in cap rates.

Marrinan pointed out that U.S. cap rate spreads over Treasuries are cyclical rather than fixed. Currently, cap rates are at or near the top of their historic range. The apartment sector has the smallest average spread, while the office sector has the largest.

As the U.S. economy recovers, she predicted, interest rates should normalize within the next five years and real estate fundamentals will continue to improve. With an improving economy, rising rental rates will favor cap rate spread compression, mitigating the potential damage to real estate valuations.

An important factor in this scenario will be the speed and timing of the Federal Reserve’s “unwinding” of U.S. monetary policy, she added. Sustained investor confidence will be critical to achieving a favorable outcome.

Another factor to watch is the excess capital in Asian and European countries with high rates of savings, much of which is expected to flow into U.S. real estate and bond markets. In particular, China’s forthcoming economic plan could unleash some $4.5 trillion in capital. This scenario also greatly favors cap rate spread compression.