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The United States issued debt at an extraordinary magnitude in response to the 2008-2009 financial crisis. The debt was priced at historically low rates as investors were and continue to be avid buyers. Bond yields are currently low - perhaps artificially low - due to investor sentiment and the Fed’s quantitative easing program.

According to a new paper issued by the Peterson Institute for International Economics (Peterson), current debt obligations in most advanced economies are projected to increase to unsustainable levels over the next 20 years unless major changes are made in expected spending and taxes. Peterson reports that net general debt in the US increased from 42% of GDP in 2007 to an estimated 73% in 2011. The Institute forecasts debt amounting to 86% of GDP in 2015 and 99% in 2020.

How does this impact your real estate investment strategies? Rising government debt levels have a direct impact on interest rates. Peterson indicates “that an increase in U.S. federal debt by 1% leads to an increase in the long-term real interest rate by 3 to 5 basis points.”  Peterson projects the “effective interest on U.S. government debt” rising from 2.8% in 2010 to 4.4% in 2015, a 1.6% increase. The Institute expects it to be approximately 5% in 2020.

The impact on capitalization rates due to higher bond yields is not linear. The pressure of pricier interest rates on cap rates may be mitigated by increased economic growth and/or lower risk premiums. Yet, it is easy to believe that cap rates trend upward during the ensuing years. The key concern for real estate investors buying today is that your exit valuation will likely be affected by higher interest and cap rates.