Taper Protection: Where to Go when Rates Rise

Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

I have fielded a number of questions from advisors about the effects of rising interest rates on real estate values. The negative effect of rising rates is predictable for fixed incomes, but real estate returns vary and are dependent on a number of factors. I will start with a historical analysis that demonstrates the strength of real estate returns during periods of rising rates. Then I’ll outline the factors that drive changes in real estate values in a rising-interest-rate environment. I’ll conclude with a discussion of why core real estate will deliver attractive returns relative to fixed-income investments in the current environment.

Recap of recent events

When the Fed signaled that its third round of quantitative easing could end more quickly than most market participants expected, interest rates spiked significantly. The 10-year Treasury yield increased 104 basis points between May 2 and July 10. This 63% increase wreaked havoc on the market, and fixed-income investors got an unpleasant reminder of the strong inverse relationship between interest rates and bond prices. The iShares Barclays Aggregate Bond Index Fund lost 3.95% in the last three months.Investors reacted by yanking $60.4 billion out of fixed-income mutual funds in June. Intermediate-term bond funds lost $24.4 billion.

Advisors are faced with a dilemma of where to place capital that is earmarked to generate income. With high-dividend-paying stocks and other yield investments bid up over the last several years, there are few attractive options. Direct core1 real estate is an optimal solution in the current investment landscape.

Historical evidence

Direct core real estate has performed well in rising-interest-rate and inflationary environments. I isolated every trough-to-peak period in the last 35 years when interest rates increased by at least 100 basis points and, as a subset of that, 150 basis points (see Figures 1 and 2). Private core real estate, as measured by the NCREIF Open End Diversified Core Equity Index2 (NFI ODCE), performed well during those time periods, averaging a 12.2% annual return when rates increased by 100 basis points or more. When rates increased by 150 basis points or more, the average return improved to 19.2% annually, due primarily to elimination of the 2008-10 period. Notably, 2008-10 was the only period in the data set when real estate returns were negative during an interest rate rise of 100 basis points or more.

1. Core real estate is characterized by high-quality real estate assets, leverage between 0% - 30%, a stable tenant base and conservative income-focused return targets

2. The NFI-ODCE is an index of investment returns reporting on both a historical and current basis the results of 30 open-end institutional commingled funds pursuing a core investment strategy.