Rising interest rates = declining property values? Not so fast...
A reader of my last article sent me an email asking if rising interest rates inevitably mean that commercial real estate values will fall.
The answer is it depends.
Cap rate expansion can certainly wreak havoc on real estate prices if fundamentals do not remain strong enough to counteract cap rate movement.
Factors such as rental growth, occupancy and redevelopment opportunities must be included in the discussion.
Consider this example. Let’s say in 3 years, cap rates for multi-family assets in your submarket are expected to increase by 50bps. Your current NOI is $250,000 and you project your NOI in 3 years to be $265,000.
Market Value today = $250,000 / 5% = $5,000,000
Market Value in Y3 = $265,000 / 5.5% = $4,818,181
Holding everything else constant, your market value would decrease nearly $200,000 if cap rates slipped by just 50bps and your asset experienced only modest NOI growth.
However, let’s say that you project rental demand in your submarket to increase significantly in the coming years. With no cranes in the air, you are confident you can capitalize on rental growth and increase NOI by 15%.
Now let’s take a look…
Value today = $250,000 / 5% = $5,000,000
Market Value in Y3 = $287,500 / 5.5% = $5,227,272
Market value can increase even while cap rates expand if NOI grows significantly enough.
The question becomes not “how much will cap rate growth decrease my property’s value?”, but rather, “can I grow my property’s NOI enough to counteract the movement?”
Of course, this is ignoring the debt market. The cost of debt is a factor to consider not only in refinancing your property during your hold period but also in borrowing for any capital improvements that may be necessary to increase NOI.
If the cost of debt is higher than the cap rate on your property, you will experience negative leverage. In layman’s terms, you will be paying more to keep the property than your property will be paying you.
All factors must be considered in deciding whether or not to hold your property.
In short...
If you are not open to the possibility of holding your property longer than anticipated and/or you feel that your property’s NOI has reached a plateau, then you should strongly consider selling.
If you are confident that you can push rents and/or occupancy enough to significantly impact NOI, then there may still be some upside waiting in the future even as interest rates rise.
Written by Anthony D'Amelio, Associate at Cushman & Wakefield, Manhattan