Commercial Real Estate Values in a Rising Interest Rate Environment

Commercial Real Estate Values In a Rising Interest Rate Environment

Two reasons real estate pros don’t mind a rising rate environment

It is inevitable; interest rates are on the rise. However, the impact of rising rates  on the value of commercial real estate portfolios is not as predictable. Investors are uncertain on whether to hold or sell their real estate assets as the spread between cap rates and the 10-year Government bond yield narrows. The natural reaction for investors is to look for alternative investments that provide a higher premium above the risk free rate. (1) Investors have long assumed that a rise in interest rates will increase cap rates, therefore decreasing the value of real estate holdings, but this is not necessarily accurate. Figure 1 (courtesy of Manulife) illustrates the inconsistent relationship between the two variables. (2)

Capitalization rate (Cap Rate)
A fundamental commercial real estate valuation tool that is used to determine the rate of return  for an investor (3)

 Return on Investment

Cap Rate = Net Operating Income / Market Value of the Property

 Market Value with a Pre-Determined Cap Rate

Market Value of the Property= Net Operating Income / Cap Rate

 Risk-free rate

The risk-free rate represents the rate of return (interest) an investor would expect from an absolutely risk-free investment over a specified period of time (4)

Although not entirely accurate, investors’ assumption of the inverse relationship between interest rates and real estate value is logical. In fact, the assumption mirrors the relationship between interest rates and bond values.  An increase in interest rate increases the “risk free rate”, and as a result the value of the asset decreases in order to maintain a competitive yield (cap rate). As the Bank of Canada continues to increase interest rates, cap rates should follow suit, right? Well not exactly. There are two fundamental reasons why many professionals believe that commercial real estate portfolios will maintain their value despite rising interest rates, which are:

  1. Transition to mixed-use developments

  2. Opportunity to increase rents

Figure 1 – Cap Rate and Risk Free Rate Relationship (2)

Source: MSCI/IPD, Bank of Canada, Manulife Asset Management, as of December 2017

1. Transition to Mixed-Use Development

REITs and developers, specifically in retail, are seeing a light at the end of the tunnel in their battle with e-commerce and now rising interest rates. The light has been provided by a provincial planning shift towards mixed-use development. A perfect example is the launch of RioCan Living, which is RioCan’s residential initiative for land holdings within the urban core. The pivot to mixed-use developments provide significant benefits for REITs and investors, which include:

Increased Intensification: The typical retail plaza has square foot coverage of approximately 25%. The other 75% is primarily dedicated to site accesses, parking, and landscaping. Simplistically speaking, how can a property receiving rent on only 1-quarter of the land be considered highest and best use? The opportunity to increase square footage on site without purchasing additional land provides a significant benefit of increasing revenue per acre of land.

Complement Existing Retail: This benefit is simple. Building multi-family condo units on the same plot of land as existing retail immediately increases the foot traffic and number of consumers that will be shopping at the plaza. The benefit of increased consumer traffic for an asset management company is long-term stable income and the flexibility to increase rents.

Increased Demand for Rental Units: The combination of the rise in interest rates and provincial “stress tests” has created significant barriers to achieving home ownership.  As a result, people need to rent! Believe it or not, there is still demand for multi-family rental housing in the GTA, especially in urban centres and close to transit.  Therefore, a rise in interest rates actually increase the demand for purpose built rentals, which plays right into the hands of REITs and developers across the GTA (5).

Liquidation and Equity Restructuring: REITs and developers are aware of their core competencies, and will not engage in development that put their shareholders at risk. For example, a retail REIT will likely decide to engage in joint venture partnerships with a residential builder, rather than build the new residential units itself. How does a joint venture partnership benefit REITs? Well REITs own the land and the first step in engaging in a partnership will be the residential builder buying a portion of the land from the REIT. The disposition of land on behalf of the REIT will result in a significant gain, and the excess cash is now available to 1) buy back shares or 2) equity restructuring to strengthen other investments within the portfolio. This is an opportunity for REITs to liquidate the equity in their land-holdings.

It is important to note that the shift in demand for mixed-use developments is within the urban core, along major roads, and near transit. Investors must be aware of their land-holding surroundings and use this initiative to identify mixed-use opportunities.

2. Opportunity To Increase Rents

Canadian commercial real estate is experiencing historically low vacancy rates, which are continuing to decline. CBRE has predicted that the historically low vacancy rates combined with a strong economic growth will result in record high rental rates (6). If we refer back to the capitalization rate valuation method, an increase in cap rate (denominator) due to a rise in interest rates can be offset by an increase in net operating income (numerator) as a result of higher rental rates. Figure 2 and Figure 3 (courtesy of CBRE), illustrates the historically low vacancy rates across Canada and Toronto, respectively.

Figure 2 – Canadian CRE Vacancy Rates

Multi-Family:

Industrial:

Office:

Figure 3 – Toronto CRE Vacancy Rates

Multi-Family:

Industrial:

Office:

It is important to note that Toronto Office space in “central” locations has a projected 2018 vacancy rate of only 3.3%.

Conclusion

In my opinion, the uncertainty between the movement of interest rates and cap rates is what makes Real Estate so unique. There are many variables to take into consideration when analyzing whether to buy, hold or sell CRE assets. A rising interest rate environment certainly changes the way investors should evaluate their investments in CRE, putting more emphasis on strategic locations close to transit, highways, and urban cores, but the rise does not solely determine the movement of CRE values. Non-core assets are more likely to see a rise in cap rates, but this will provide private investors with an opportunity to add a community CRE property to their portfolio, as they were previously being priced out of the market. My opinion is aligned with many of those in the articles listed below, that commercial real estate is poised for continued growth and is a strong asset class to include in your investment portfolio.

Sources:

  1. McLean, S. (Jan 1 2018). Good year in store for CRE 2018: C and W. Renx – Real Estate News Exchange. https://renx.ca/cre-good-year-ahead-2018-cap-rates-report/
  2. (March 2018). Canadian Commercial Real Estate Outlook: Will Rising Interest Rates Impact Canadian Commercial Real Estate Values? Manulife Asset Management.http://www.manulifeam.com/ca/Research-and-Insights/Market-Views-And-Insights/Canadian-Commercial-Real-Estate-Outlook-Will-Rising-Interest-Rates-Impact-Canadian-Commercial-Real-Estate-Values/
  3. Capitalization Rates. https://www.investopedia.com/terms/c/capitalizationrate.asp
  1. Risk Free Rate of Return. https://www.investopedia.com/terms/r/risk-freerate.asp
  1. Dias, D. (June 14 2018). Even rising interest rates can’t stop traditional retail REITs from cashing in on shift to residential. Financial Post. http://business.financialpost.com/investing/even-rising-interest-rates-cant-stop-traditional-retail-reits-from-cashing-in-on-shift-to-residential
  1. (2018). 2018 Real Estate Market Outlook. http://www.cbre.ca/EN/mediacentre/Pages/With-Commercial-Real-Estate-Transactions-Topping-$43-Billion-in-2017,-CBRE-Forecasts-2018-could-break-Investment-Record-for.aspx

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About the Author

Jordan Holt
Jordan HoltVP Communications
Jordan is an MBA candidate specializing in real estate and infrastructure. Prior to his enrollment at the Schulich School of Business, he worked for an experienced GTA developer. His primary focus was on the acquisition and financing of large-scale developments. Jordan also holds a Bachelor of Commerce degree from the University of Guelph.

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