Thinking through the implications of interest rate increases

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Right now, the thing on everyone’s mind in real estate is the likely impact of increasing interest rates on asset values.

As the economy continues to improve, the stage is being set for the Fed to increase rates in order to manage inflation.

The Fed would probably have done this anyway, but Trump’s proposed combination of tax cuts and infrastructure spending are likely to be highly inflationary, likely leading to quicker and more forceful action.

Real estate values are highly dependent on interest rates. As rates go up, values go down, all things being equal.

So, the question is, are we in for a long period of rate increases and declining in asset values?

I think not, and here’s why: Interest rates don’t rise in a vacuum; they do so in response to rapid growth in the economy.

Rapid growth results in two things, both good for asset values:

  1. As businesses grow, they tend to generate more and more cash for their owners. These people need to do something with the cash… and some portion of it will end up in real estate, because other assets (like stocks and bonds) will also look expensive;
  2. As business grow, they employ more people for more money. This ought to result in increased demand for apartments and, therefore, increases in achievable rents.

The second factor is the one that is important to me (since I’m not a seller of real estate). The question is: How much do rents need to rise to counteract a rise in interest rates and, therefore, a rise in cap rates?

Assume you own the following building in:

  • Rents: $120k / year
  • Expenses: $35k / year
  • NOI: $85k / year

At a 5% cap, that building is worth $85k / 0.05 = $1.7MM.

If if interest rates move up by a full point and cap rates do to, then your building is worth $85k / 0.06 = $1.42MM.

But here’s the thing: If rents move up 15% (which is about two years worth of growth in a very strong economy), your building looks like this:

  • Rents: $138k
  • Expenses: $35k
  • NOI: $103k

And the value is $103k / 0.06 = $1.71MM… in other words, back to where you were prior to the full point increase.

Obviously the above example is a bit simplistic (expenses grow, too!). But it gets to the heart of the issue: Even a relatively sharp spike in rates triggering a 100 basis point up-tick in cap rates is swamped by a 15% rent increase.

Since rates generally only rise in response to strong growth, I’m not overly concerned about this new environment into which we’re heading.

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