Conventional wisdom holds that interest rates and capitalisation rates move in lock step. Rising interest rates can lead to higher capitalisation rates, which, in turn, lead to lower property values. That, the thinking goes, will have an impact on total commercial real estate returns. That’s why property trust investors worry about rising rates.
Maybe they shouldn’t be worrying so much. For a few years now, Australian interest rates have been at or near historic lows. In fact, the Reserve Bank cash rate of 1.50% is unchanged since July 2016 with key indicators pointing to minimal change.
Still, as we’ve seen in the US recently, the interest rate cycle has changed with rates now increasing. For investors in Australian Listed Real Estate Investment Trusts (AREITs) there are three factors that should arrest any concerns when this occurs here:
1. Rising rates do not necessarily lead to lower property performance
On this issue at least, historical data suggests conventional wisdom is misplaced. Higher interest rates do not necessarily result in lower property values and total returns. In fact, property performance has often remained resilient in times of rising rates.
That makes sense when you think about it. If interest rates are rising because of stronger economic growth, higher wages and buoyant consumer demand, as is currently the case in the US, demand for real estate is likely to be growing rather than falling. For AREITs this is great as stronger tenant demand means higher rents.
AREITs’ performance over the past year has been more correlated with bond yields than in previous periods (bond yields being a key reference rate for the sector). The markets focus on the yield trade (investing in AREITs to generate higher income as traditional income investments such as bonds are at extremely low yields) being a key driver of this relationship. However recent research from Citi indicates that the bond yield/AREIT performance correlation “is far from stable over time, varying both in strength and direction” (Citi, Jan 27 2017). Their view is that AREIT performance has a stronger relationship to cap rate movements than bond yields over the long term. The following chart highlights the correlations between AREIT performance, cap rates and bonds since 1993. It shows that both retail and office cap rates have a stronger correlation to AREIT performance over the long term hence their view that “the markets focus on bond yields as a driver of REIT performance should moderate over 2017.”
This isn’t to say that when rates eventually rise in Australia it won’t have an effect on property values. But it is far from certain that they will. Moreover, if local rates increase, but remain at or below long-term averages as we expect, commercial real estate would be well positioned to benefit.