Will Rising Interest Rates Drive Down Commercial Real Estate Prices in Connecticut?
Posted on by Rachel Gretencord
In their March meeting, the Federal Reserve Bank voted to raise the target federal funds rate to 1.5-1.75%, with rates expected to climb to 2.9% by 2019 and 3.4% by 2020.1
All else being equal, an increase in interest rates could lead to a decrease in commercial property values. As interest rates climb, the return on alternate types of investments may increase, making real estate comparably less attractive and driving prices down. Additionally, since most real estate assets are financed, a rise in interest rates would increase the investor’s borrowing costs, driving investors to seek either an increase in operating income2 from the property or a decrease in the market value of the asset.
However, many other elements impact property values, including local market conditions, asset quality, inventory, the demand for specific types of space, and investor risk tolerance. Historically, while there is some evidence of correlation between interest rates and capitalization rates,3 it is not a direct causal relationship due to these local factors. For example, steady economic growth, such as is currently projected by the Fed on a national basis, could lead to an increase in demand for space and, therefore, a decrease in vacancy or an increase in the rents that landlords can charge. This, in turn, would increase the net operating income of a property, offsetting some of the downward price pressure from rising interest rates. Similarly, studies of the relationship between cap rates and interest rates have found such correlations to hold over the long term, but in the short- to medium-term, there are significant intervals of time in which the correlation is zero, or even negative. As such, interest rates alone cannot be used to predict changes in the cap rate with certainty.4
While Connecticut experienced negative real GDP growth from 2008-2014, the state’s economy is now growing again—albeit slightly more slowly than at the national level. Likewise, the labor force growth rate is anticipated to remain modest, near 0.5%, for the 2018-2020 period, and unemployment is anticipated to rise from 5.0% in 2017 to 5.7% by 2020.5
Given these economic conditions, if the rising interest rates do put a squeeze on cap rates, Connecticut may feel the pinch sooner than other regions of the country with more robust growth. However, as interest rate changes over the coming months are anticipated to remain slow, gradual and predictable, local market conditions will likely have a stronger impact on prices for specific assets than will changes in interest rates alone.
Do you have questions about the financial performance of your real estate asset or development project? CERC can provide market data, fiscal impact studies, pro forma analyses and technical assistance, or help guide you to the right resources for your project’s success.
1Federal Reserve Bank of St. Louis and U.S. Federal Open Market Committee, FOMC Summary of Economic Projections for the Fed Funds Rate, Median [FEDTARMD], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/FEDTARMD, April 8, 2018.
2Net operating income (NOI) refers to the income generated by a property’s operations. NOI includes all revenue produced by the property minus operating expenses such as real estate taxes, insurance, utilities, general and administrative costs, and operating and maintenance expenses. “Below the line” costs such as tenant improvements, leasing commissions, capital expenditures, or financing and ownership expenses (such as mortgage payments) are not a part of the NOI calculation.
3A capitalization rate, or cap rate, is a percentage that measures the portion of the total asset value (or price) represented by the first year net operating income. So, for example, if a property’s NOI is $100,000, and the price is $1.2 million, the cap rate would be 8.3% ($100,000 / $1,200,000).
4For example, TIAA Global Asset Management found a correlation of 0.7 between the NCREIF Property Index transactions cap rate and 10-year treasury yields over a 23-year period from 1992 to 2015, but no statistically significant relationship when using treasury yields to forecast cap rate changes. Martha Peyton and Edward F. Pierzak, “Real estate: The impact of rising interest rates,” Summer 2016, https://www.tiaa.org/public/pdf/real_estate_the_impact_of_rising_interest_rates.pdf, Accessed April 8, 2018. The National Association of Real Estate Investment Trusts also noted that several asset classes (including office, industrial, and multifamily) are experiencing the lowest cap rates since 2001, despite the recent interest rate increases. Calvin Schnure, “Cap rates hold their ground as interest rates move higher,” NAREIT Industry News, December 7, 2017. https://www.reit.com/news/blog/market-commentary/cap-rates-hold-their-ground-interest-rates-move-higher, accessed April 9, 2018.
5Connecticut projected figures from the New England Economic Partnership Fall 2017 Forecast. Note that with increasing economic growth, unemployment may increase due to workers re-entering the workforce, which is not necessarily a bad thing; but unemployed workers do not generally contribute to an increased demand for commercial real estate.
6Actual figures from U.S. Bureau of Economic Analysis, Real Total Gross Domestic Product for Connecticut [CTRGSP], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CTRGSP, April 9, 2018, and U.S. Bureau of Economic Analysis, Real Gross Domestic Product [GDPCA], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/GDPCA, April 9, 2018. Projected figures for Connecticut from the New England Economic Partnership Fall 2017 Forecast and for the US from Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents under their individual assessments of projected appropriate monetary policy, March 2018, https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180321.pdf, April 9, 2018.