Real estate investment trust prices have dipped the last few months, probably on expectations of rising interest rates on commercial mortgages. On the positive side, total returns for investment real estate, which include both operating earnings and price appreciation, have averaged 13 percent over the past four quarters, based on the properties surveyed by National Council of Real Estate Fiduciaries.
Office vacancies continue to decline gradually, as do retail vacancies. Loan default rates on such properties continue to be low. Hotels are doing well, with average revenue per room up by 6.4 percent in the past year.
In short, this current environment of moderate economic growth (excluding the first quarter) and low interest rates has been positive for commercial real estate investors. The graduated improvement in vacancy has delayed new projects, so competition is not too strong.
Higher interest rates are always feared by commercial real estate investors, but it is important to understand why interest rates would rise. If a malevolent pixie scattered monetary tightening dust, then real estate values would fall. Today’s value of a property is the discounted value of future earnings, and higher interest rates discount those earnings by a greater amount. Another way to think of it is that many purchases don’t work with higher interest rates.
However, the Federal Reserve is hardly an evil pixie. The Fed will raise interest rates only when they see further strength in the overall economy. That strength in the economy will boost occupancy and rents, improving operating earnings. In the early stages of Fed tightening, the stronger economy dominates. In two years or so, the slowdown in the economy combines with the higher discount rates to hurt commercial real estate.
Although the Fed can peg short-term interest rates, such as the one-year treasury, it has less control over longer-term interest rates. The 10-year bond, for example, is driven more by global demand for credit and supply of savings than by Fed policy. Thus, it may not be Fed policy that pushes up commercial mortgage rates.
Commercial investors will most likely see good total returns in the next two years, but it’s worth considering what could go wrong. International recession, originating in Europe or China, could trigger a downturn in the United States, ruining occupancy and rents in 2016. Looking farther ahead, if the Fed’s tightening proves to be too much, too soon, then a recession would begin in 2017, most likely. Thus, the positive returns that are the best forecast right now are not guaranteed. And if you didn’t know that already, you have no business investing in real estate.