Insight: Getting Real on Rising Interest Rates
The relationship between interest rates and real estate values is far more nuanced than some may lead you to believe.
By: Chris Marsh and Austin Maleki, Revitate Cherry Tree
January 26, 2022
Real estate investors and analysts are abuzz about the upcoming impacts of persistent inflation and rising interest rates. But while tracking the spread between treasuries and cap rates provides solid insight into the broader economic landscape, it’s not a tell-all indicator that many assume.
Savvy investors understand the age-old adage: it’s all about the fundamentals. Supply and demand. Fund flows. Capital markets. Broader economic activity.
Simply put, there is limited evidence suggesting a true 1:1 linear relationship between a move in treasuries and a move in property cap rates.
Additionally, contrary to popular belief, history shows that rising interest rates generally occur during times of economic growth and expanding employment, which are two of the largest drivers of apartment demand, and generally have led to flat or lower cap rates.
Several respected academics have discussed this phenomenon.
A 2011 paper by Philip Conner found that during six periods of rapidly rising interest rates between the late 1970s and the global financial crisis in 2010, cap rates usually remained flat or decreased:
“Treasury yields typically rise during periods of economic growth and expanding employment, which serve as a catalyst for improving space market fundamentals and increasing risk appetite. The compression in corporate bond yield spreads during five of the six periods illustrates how investors’ appetite for risk changes when long-term rates are rising. From an appraisal perspective, a strengthening macroeconomic environment and more bullish investor sentiment should offset at least some of the adverse effects of the higher benchmark rates through adjustments to rent/income growth rates and discount rates.”
Similarly, former Wharton Professor Peter Linneman recently had this to say when asked about the correlation between treasuries and cap rates:
"Here's the thought experiment… Suppose you knew they'll be twice as much money chasing apartments a year from now, as there is today. Are we going to have twice as many apartments a year from now as we do today? No, we'll have 1.5% more apartments and twice as much money trying to get to it. What happens to cap rates? They go down. You and I could argue about how much to go down. But you don't have to, by the way, did you ask me what are interest rates? It's not about interests. It's about the weight of the money."
No one truly knows with certainty where cap rates are going in the future, which is why Revitate Cherry Tree’s investment strategy focuses on what’s in our control as capital allocators and operators:
Buying assets in well-located and supply-constrained markets that have long term growth prospects
Buying well-positioned properties at an attractive basis to replacement cost and market comparables with moderate, well-priced leverage
Operating our properties using an institutional and well-proven asset management strategy, which we think will add inherent value over the long-term
At Revitate Cherry Tree, we believe our value as a best-in-class operator, coupled with a hybrid approach to investing in both multifamily workforce housing and value-add opportunities in the Midwest and Sunbelt, provides investors with a unique balance of both income and growth in long-term, high-quality markets. Just as importantly, our focus on social impact led by the preservation of affordable housing, the incorporation of community learning centers, and active community building in the markets where we operate is at the forefront of our mission and strategy.
It’s a time-tested approach we believe is well-positioned for whatever economic conditions lay ahead.