We all remember how the Great Recession impacted our investment choices. Money flooded out of the stock market with the typically-safe bond market even shaken by the largest financial crisis since the 1920s. Yet, eight years later, we are in the middle of the third-largest bull market, and all key economic indicators have compelled the Federal Reserve to start normalizing interest rates.
While we have economic expansion to thank for today’s rate increases, they don’t come without some investment uncertainty. If you invest in real estate, it’s imperative to understand how this rising rate environment may affect your investments.
When rates rise, what really matters?
As rates rise, various investments may react differently. For example, rising rates erode a currently-held bond’s principal. If you own one of these bonds, you can choose to watch its value steadily erode or sell it off at a discount.1 Stocks may also have a negative reaction to rising rates. When rates go up, interest payments on debt rise. This may dilute a company’s available cash flow for investment and dividend payments, which can lead to lower share price growth.2
Most real estate, however, has the potential to perform well in a rising rate environment. According to Forbes, REIT stocks outperformed the overall market in a rising rate environment that occurred from June 2004-August 2006. During this time frame, REITs returned over 60 percent compared to the S&P 500’s return of 20 percent.3 In addition to comparing real estate to the S&P 500, the chart below points out how real estate has performed compared to treasuries and bonds during recent periods of rising rates, according to Bloomberg.
While it’s true that real estate can suffer short-term interest rate shock, what really drives its performance long-term is a healthy, growing economy.4 Our current interest rate hikes signal a healthy economy with unemployment dropping to 4.3 percent in July 2017 and hourly wages rising 5 percent to $26.36.5
While it’s true that real estate can suffer short-term interest rate shock, what really drives its performance long-term is a healthy, growing economy.4
However, real estate casts a wide net, and different sectors and investment structures may react differently in these environments. Higher lending rates may lead to lower cash returns for investments in leveraged properties, and high mortgage rates may mean increased purchase costs for investment properties.6 However, real estate with short-term leases, including storage, hotels, and multifamily can capture the income generated by a property to keep pace with the growing economic footprint.6
Apartment supply and demand imbalance
Let’s take a quick look at one of these sectors. As mortgage rates increase in a growing economy, potential buyers have more capital, but still may shy away from purchasing homes. As more potential buyers become renters, competition for good rental properties will increase and could help reduce overall vacancy rates. As demand grows and the completion of new supply continues to lag, rents will increase. Higher rents have the potential to increase cash flow and net operating income for apartments and generate income for your portfolio.7,8
What lies ahead?
The Federal Reserve has raised the short-term rates four times since December 2015, while indicating the potential for additional increases through 2019. Along with the potential for expansionary fiscal policy under Donald Trump’s administration, forecasters see an expanding economy and rising rates in our future.
Overall, this rising interest rate environment is a potential positive for most aspects of real estate, especially properties that utilize short-term leases. It’s tied to healthy economic growth, which can translate into greater demand for real estate. Businesses could look to expand and more people could afford housing, supporting growth in real estate earnings, cash flow, and dividends.4