The Impact of Interest Rates on Cap Rates
By: Ellen Rand, freelance writer and former contributing editor, Development
What’s the outlook for the economy and for interest rates for the rest of the year? Steady as she goes, as long as the Federal Reserve makes no sudden drastic changes to its monetary policy. Rates are likely to rise moderately over the next 18 months to two years, with steadily improving employment and a gradual pickup in inflation. That’s how JLL sees it, as the company recounted earlier this year in its “Interest Rate and Cap Rate Perspective” report.
For investors, how might rising interest rates impact cap rates and property values? To address that question, JLL constructed three different scenarios: a healthy growth case, a sluggish growth case and a correction case. Based on its current forecasts and expectations, JLL sees a 55 percent probability of the healthy growth case, with GDP growth accelerating to 3 percent or more between 2014 and 2016, unemployment dropping to below 6 percent in 2015 and inflation gradually picking up from a very low level. Interest rates could rise by 90 basis points in two years to 3.6 percent.
The sluggish growth case, to which JLL assigns a 35 percent probability, includes GDP growth struggling to reach 2 percent; unemployment edging down, but slowly; and inflation remaining below the Fed target through 2015. Property values would continue to increase modestly, though, and real estate would continue to be seen as a favorable investment. As a result, the spread between cap rates and Treasuries would decrease modestly.
By contrast, in its correction or “run for the hills” case, to which it assigns a 10 percent probability, GDP growth would decline and feature a financial event-driven recession, while unemployment would rise to higher than 7 percent by the end of 2014 and inflation would drop, raising concerns about deflation.
In the healthy growth case, real estate fundamentals improve, with rent growth outstripping inflation and property values increasing. Cash flows should be seen as increasingly less risky and commercial real estate should remain a relatively favored asset class. JLL sees the spreads between interest rates and cap rates continuing to compress; in this scenario, cap rates should only marginally increase over a two-year period.
Two months after the report was issued, and following the June 2014 Federal Open Market Committee meeting, Marisha Clinton, director of capital markets research at JLL, noted that its forecasts are coming to fruition and that cap rates, going forward, should remain flat. Property values should continue to rise.
In late July, the Fed announced: “In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in August, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $10 billion per month rather than $15 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $15 billion per month rather than $20 billion per month.
“The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.”
If the Fed continues its current course, tapering could wind down between November 2014 and January 2015. It is imperative to continue watching the Fed’s tapering actions (reducing the Federal Reserve’s asset purchase program), Clinton said, but added that she expects “no major surprises.”
Indeed, JLL did not construct a scenario calling for a sizable and quick interest rate spike, because it sees this as a remote possibility. Were that to happen, though, cap rates also would likely increase significantly.