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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 Index
2 (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.
I conducted the same analysis for the Barclays Aggregate Bond Index. The broad fixed income benchmark did not perform well during these same periods, averaging a -0.4% annual return during rate increases of 100 basis points or more and a -3% annual return during rate increases of 150 basis points or more. The average return for the Barclays AGG during rate increases of 100 basis points or more benefited from strong performance during the 2008-10 period (up 7.8% each year), as investors looked for a safe haven from the turbulent equity markets.
Figure 1: Trough to Peak Periods where 10 Yr UST Yield Increased by at least 1%
|
Dates
|
10 Yr Treasury Yield
|
NFI ODCE
Total Return
|
Barclays Agg
Total Return
|
NFI ODCE Avg
Qtr Return
|
Barclays Agg
Avg Qtr Return
|
Trough
|
Peak
|
Trough
|
Peak
|
Increase
|
12/31/77
|
3/31/80
|
7.7%
|
12.8%
|
5.1%
|
49.7%
|
-5.6%
|
5.5%
|
-0.6%
|
6/30/80
|
9/30/81
|
9.8%
|
15.3%
|
5.5%
|
21.5%
|
-9.0%
|
2.4%
|
-1.0%
|
3/31/83
|
6/30/84
|
10.5%
|
13.6%
|
3.1%
|
19.2%
|
3.1%
|
2.1%
|
0.3%
|
12/31/86
|
9/30/87
|
7.1%
|
9.4%
|
2.3%
|
5.2%
|
-2.9%
|
0.6%
|
-0.3%
|
12/31/89
|
9/30/90
|
7.8%
|
8.9%
|
1.1%
|
3.0%
|
3.7%
|
0.3%
|
0.4%
|
9/30/93
|
12/31/94
|
5.4%
|
7.8%
|
2.5%
|
6.8%
|
-2.9%
|
0.8%
|
-0.3%
|
12/31/95
|
3/31/97
|
5.7%
|
6.7%
|
1.0%
|
14.9%
|
3.0%
|
1.7%
|
0.3%
|
12/31/98
|
12/31/99
|
4.7%
|
6.3%
|
1.6%
|
13.2%
|
-0.8%
|
1.5%
|
-0.1%
|
6/30/03
|
6/30/04
|
3.3%
|
4.7%
|
1.4%
|
10.7%
|
0.3%
|
1.2%
|
0.0%
|
6/30/05
|
6/30/06
|
4.0%
|
5.1%
|
1.1%
|
19.2%
|
-0.8%
|
2.1%
|
-0.1%
|
12/31/08
|
3/31/10
|
2.4%
|
3.7%
|
1.3%
|
-29.2%
|
7.8%
|
-3.2%
|
0.9%
|
Average Total Return ----->
|
12.2%
|
-0.4%
|
1.4%
|
0.0%
|
Figure 2: Trough to Peak Periods where 10 Yr UST Yield Increased by at least 1.5%
|
Dates
|
10 Yr Treasury Yield
|
NFI ODCE
Total Return
|
Barclays Agg
Total Return
|
NFI ODCE
Avg Qtr Return
|
Barclays Agg Avg Qtr Return
|
Trough
|
Peak
|
Trough
|
Peak
|
Increase
|
12/31/77
|
3/31/80
|
7.7%
|
12.8%
|
5.1%
|
49.7%
|
-5.6%
|
5.5%
|
-0.6%
|
6/30/80
|
9/30/81
|
9.8%
|
15.3%
|
5.5%
|
21.5%
|
-9.0%
|
4.3%
|
-1.8%
|
3/31/83
|
6/30/84
|
10.5%
|
13.6%
|
3.1%
|
19.2%
|
3.1%
|
3.8%
|
0.6%
|
12/31/86
|
9/30/87
|
7.1%
|
9.4%
|
2.3%
|
5.2%
|
-2.9%
|
1.7%
|
-1.0%
|
9/30/93
|
12/31/94
|
5.4%
|
7.8%
|
2.5%
|
6.8%
|
-2.9%
|
1.4%
|
-0.6%
|
12/31/98
|
12/31/99
|
4.7%
|
6.3%
|
1.6%
|
13.2%
|
-0.8%
|
3.3%
|
-0.2%
|
Average Total Return ----->
|
19.2%
|
-3.0%
|
3.3%
|
-0.6%
|
Next, I calculated the rolling three-year correlation between the NFI-ODCE Index and 10-year Treasury rates. Real-estate returns and 10-year Treasury rates had a minimal 0.1 correlation over that time period.

I also calculated the rolling three-year correlation between the Barclays AGG and 10-year Treasury rates. Not surprisingly, the broad fixed income benchmark and 10-year Treasury rates showed a strong negative correlation (-0.89). This lends statistical support to what you already know – when rates rise, bond prices fall.

Based on the historical information described above, private core real estate has performed well during rising-interest-rate periods and has been uncorrelated with changes in interest rates. The broad fixed income market has performed poorly during periods of rising interest rates, and prices were negatively correlated with changes in interest rates. In an attempt to better understand why each asset class has performed as described above, let’s evaluate the factors that drive returns.
Factors that drive returns
To determine the value of an asset, investors discount expected future cash flows at a rate that is impacted by current interest rates. The discount rate takes into account the time value of money (which increases as interest rates rise) and the uncertainty of future anticipated cash flows. As interest rates increase, the value of bonds and real estate decreases, because the discount rate increases.
Unlike bonds, where future cash flows are contractual, future cash flows in real estate are variable and can increase over time. Increasing cash flows mitigate the impacts of rising interest rates. One of the keys to understanding how real estate will perform in a rising-interest-rate-environment is determining if it will generate increased cash flows.
These variables can affect real estate returns:
Real estate fundamentals: Supply and demand drive real estate returns. If demand outpaces supply, the owners of real estate can raise rents, increasing cash flow. If supply outpaces demand, landlords may compete to attract scarce tenants by lowering rents, which would decrease cash flows. Generally, in periods when interest rates increase, the economy is improving. As the economy improves, real estate demand improves, which creates income growth as long as the supply of real estate is not in excess of demand.
Relative value of real estate to other asset classes: Investors evaluate the entire universe of opportunities and allocate capital to those areas which, on a relative basis, have favorable expected return and risk characteristics. The relative effect of rising interest rates on real estate depends on the difference between expected income returns from real estate and expected returns from other financial assets. If the spread is wide, the valuation impact would be negligible. But, if the spread is narrow, the impact would be significant because investors would shift capital to other assets.
Current state of the real estate market
So how do these variables look today? The demand for real estate has improved along with the economy since the global financial crisis. New supply of real estate has remained muted. With increasing demand and limited supply, I expect real estate to deliver above-average income growth in the near- to mid-term. If interest rates increase because of improving economic conditions (job growth, improvements in the housing market, etc.), demand for real estate will increase, which bodes well for the asset class.
Market participants are moving capital to yield-generating areas of the market in a search for income. We have witnessed a significant narrowing of credit spreads in all areas of the fixed-income markets, as well as significant capital moving toward dividend-paying areas of the equity markets, driving down the yields on those investments.
Private real estate has also benefited from increasing capital flows, but not to the extent of publicly traded yield-oriented securities. For example, because investors can buy dividend-paying stocks or bonds more easily than they can buy commercial buildings, capital has flocked to these areas more quickly and in greater magnitude than it has to direct real estate. This bids stock and bond prices up and pushes yields down. Over time, this pattern has led to a private real estate yield premium. In the current environment, real estate is trading much higher than Treasury yields compared to historical norms, even after the recent spike in the Treasury rates.
Conclusion
In the last 35 years, core real estate has been a strong performer during rising-rate environments. Investors who do nothing with their fixed income allocations will lose money should rates continue to rise. If rates stabilize, then fixed income investors can expect to earn very little in light of the still-tepid returns across the yield curve.
It makes no difference whether the rate move in May and June was just a warning for bond investors or the beginning of a longer trend of rising rates. Investors should not have to choose between losing money and earning very little. Core private real estate is well-positioned regardless of whether interest rates increase or stay muted in the next few years, given its fundamentals. Furthermore, with institutional real estate managers forecasting unlevered core real estate returns of 8.1% annually from 2013 to 20153 with 60-70% of that return derived from income, bond investors can solve their interest rate and income woes by allocating to core real estate.
Casey Frazier is the CIO of Versus Capital, an asset manager, exclusively focused on real estate investment products.
3. Pension Real Estate Association (PREA) Consensus Forecast Survey of the NCREIF Property Index- Q1 2013 Summary Results
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