Oh, to be world's biggest private-equity real estate firm right now.

Blackstone Group is apparently planning to take at least two of its real estate units public in the next several months: IndCor Properties and Invitation Homes, the owners of industrial and single-family home assets, respectively. The firm has already had a string of successful IPOs over the course of the year, including Hilton Worldwide Holdings and Brixmor Property Group.

Meanwhile, the stock market is still in its bear run and property values are 11% above August 2007's peak, having risen 7% in the past 12 months and 2% since July, according to the Green Street Commercial Property Price Index.

“Declining cap rates and higher operating income have been pushing values higher,” Green Street analyst Peter Rothemund says. “That's likely to continue.”

In other words, valuations couldn't be better for a public offering of real estate right now—perfect, in other words, for a company that scooped up many of these assets at discounts during and immediately after the recession. A textbook exit.

Unfortunately for those investors that don't fit Blackstone's profile, the question of exit strategies has gotten trickier as the market tries to parse what the Federal Reserve Bank is going to do about interest rates.

Simply put, the direction of interest rates—and when they will finally start to rise—is among the most important economic issues for the year. Interest rates, of course, could be called a perennial issue of importance, but 2014 is a shade different as economists, businesspeople and policymakers become increasingly worried that the Fed is waiting too long to pull the trigger.

The argument for the Fed to start raising rates sooner rather than later is straightforward: the recession is long over and the unemployment rate has dropped dramatically over the course of a year.

The argument for the Fed holding off on raising rates is equally compelling: there's little indication of inflation in the economy and, more importantly, wages aren't rising and the jobs created after the recession don't pay as much as the ones that were lost. In addition, yields on US Treasuries are at a 14-month low, thanks to investors seeking a safe haven from global turmoil—but also signaling a confidence in the central bank.

For the most part, the market has it easy: Fed chair Janet Yellen has all but hired a skywriter to signal her intentions: later rather than sooner, and less rather than more. Instead, the Fed will almost certainly scale back its monthly purchases of Treasuries and, for the time being, that will be its main liquidity play, says Lawrence Goldstein, SVP at NAI Hunneman in Boston.

“They will not raise interest rates until there is no longer the need for them to buy Treasuries, thus reducing the current stimulus to zero,” Hunneman predicts. “Once this has been achieved we will see the rate increased slowly within the following six months, that rate will continue to rise as the economy grows, and not a minute sooner. This will be done so that they will not cause upward pressure on incomes, or allow the economy to 'overheat,' which would be the impetus for inflation.”

That doesn't mean the subject is moot. In the longer term, interest rate increases could begin to impede commercial real estate valuation growth, Peter Muoio, chief economist at Auction.com Research, says. “This will vary substantially by segment and market, however, as different segments and markets now sit at varying cap rate spreads versus treasuries. Those with tighter cap rate spreads will be at greater risk for cap rate increases in a rising rate environment, potentially limiting valuation gains, especially in instances where NOI growth slows as occupancies approach very high levels.”

There is also this, Muoio says: rising rates could offer better options for investors than the relatively attractive yields that real estate currently offers. Higher rates could give investors a broader spectrum of higher yielding assets.

Rising rates will also upend the strategies companies are pursuing if they are predicated on cheap money, such as value-add development, Lee Kiser, principal of Chicago-based Kiser Group, says. “Currently, CMBS is back to full strength and offering low-interest-rate, high-leverage, non-recourse debt on 10-year terms with a 1% assumption fee. The value play now is to refinance with as high an LTV as possible.”

Then there is the worst-case scenario posed by Dean Pappas, a partner in Goodwin Procter's Real Estate Capital Markets Group: what if the Fed loses control of interest rates? “What if the demand for Treasuries collapses and interest rates naturally float upward but the economy is not fully healed?”

RISING CONSTRUCTION COSTS

At the same time, there's another cloud looming on the horizon, one that is coming in perhaps faster than the specter of rising rates. Construction costs have risen sharply in recent months, with the price of steel alone jumping some 40% over a 90-day period. Consulting firm Rider Levett Bucknall says US construction costs rose 1.15% in the first quarter of 2014, the largest three-month increase since 2008.

Value-add investments are one obvious choice for companies seeking refuge from rising interest rates, but the rising construction costs makes that calculation a little harder. Construction bids are 8-10% higher than six months ago, says Steve Fifield, chairman and CEO of Chicago-based Fifield Cos. “That concerns us most. We're already building in five- to seven-year term borrowing rates at 5.5-6% for projects that stabilize in 2016 and beyond, versus today's 3.5-4.4% rates.”

Rapidly increasing construction costs, however, have made it very difficult to hold to construction budgets from the point of planning to substantial completion, Lydia Stefanowicz, partner at Edwards Wildman Palmer, also points out. “A lot of the cost increases are attributable to shortages resulting from a failure by suppliers to anticipate increased demand for building products and from increased use of just-in-time inventory policies that are based on post-2008 demand patterns, rather than inherent shortages of building materials.”

FINDING REFUGE IN VALUE-ADD?

The rising construction costs also complicate one obvious refuge for rising rates: value-add and opportunistic investments.

On its own, the case for value-add and opportunistic investment in a rising rate environment is fairly straightforward for several reasons, Seth Weissman, a partner with Jeffer Mangels Butler & Mitchell LLP in Los Angeles, tells GlobeSt.com. Rates rise to reflect a tightening of credit and a fear of inflation, which are byproducts of a growing economy. Stabilized properties, therefore, are in high demand, including those that a few years ago would be classified as distressed, he explains.

“Many investors are selling those properties and looking to complete tax-deferred (1031) exchanges. This is creating increased demand for stabilized properties for investors who are looking to protect their tax basis and not have to invest substantial additional capital in the replacement properties.

Prices for those properties are rising based more on the need to close an exchange than because of the underlying fundamentals, Weissman continues. As rates rise, if that exchange market tapers, there will be price pressure on top of a generally lower going-in expected return, such as buying at low cap rates.

“Conversely, if a property has more up-side potential going in, and there is a supportive underlying economy, there is more chance to add value, which may off-set the price pressure that rising interest rates may cause. Of course, if the 1031 market remains strong and the stock market continues to taper, we will likely see continued demand for real estate assets of all types. “

Another issue to consider is that opportunistic and value-add plays will have more room to adjust to price and assumptions on exit cap rates and still keep deals attractive, points out Chauncey M. Swalwell, a partner with Stroock & Stroock & Lavan LLP in Los Angeles.

Meanwhile, with core and similar assets, “sellers already are pushing the pricing and cap rate limits in the current market so much that even small increases in interest rates will push tight underwriting over the edge for those buyers.”

Also, the going-in cap rates are generally less compressed for opportunistic and value-add deals, Auction.com Research's Muoio says. “The NOI growth needed to counterbalance rising cap rates, to the extent increasing interest rates puts upward pressure on caps, is geometrically higher the lower the going-in cap rate. Additionally the property-specific turnaround potential provides investors with return potential beyond market-driven property segment valuation changes.”

These arguments are hardly secret though and one problem with opportunistic and value-add investments is that there can be a lack of them as investors converge on these opportunities.

Another problem is that they tend to count on rental rates that continue to rise in order to offset increased interest rate and construction costs.

But what if that doesn't happen?

WATCHING RENTS RISE—AND FALL

Rising rents, obviously, can salvage many bad guesses about interest rate increases and surges in construction prices. Conversely, unexpected drops in demand could depress rent and exasperate the consequences of a poor decision.

Just as obviously, this is a question of asset class and market and submarket. Office rents in San Francisco are set to top Manhattan's. Washington, DC's office rental market? It's not nearly as robust, although still faring relatively well.

Much depends on the market, says Stefanowicz of Edwards Wildman Palmer, but in general she doesn't think rents are rising fast enough. “While demand for class A industrial warehousing in proximity to large metropolitan areas has improved, rents in that segment and some top urban office markets have strengthened, rent increases in many geographic areas remain weak,” she says.

To be sure, there is plenty of room for nuance, if not outright disagreement in what constitutes the best exit in this part of the cycle.

Jim Evans of Friedland Realty Advisors, for instance, thinks that value-add will weather an interest rate rise, but so will other select assets. “Other properties that would be able to withstand a higher interest rate environment would be those where the expenses are stopped, such as NNN type deals, and the leases have bumps in the rent that will protect the landlord's exposure to increased debt service,” he says.

Development is also an alternative exit, says Ross Yustein, chair of the real estate practice at Kleinberg Kaplan in New York City. “Many of my clients are taking on the risk of ground-up development projects for the better potential returns they can provide,” he says. “These projects have come in a variety of sectors, including luxury hotels and high end condos in Manhattan, mid-level apartment rentals in growing smaller cities, and medical office and retail properties in a number of states.“

Also, he continues, some of his clients see medical office as a particularly good way to combine the value-add that construction brings with a sector that has unique factors working in its favor. 

SIDEBAR: 
FUNDING STRATEGIES

Scott Crowe, global portfolio manager of the Resource Real Estate Diversified Income Fund in New York City, says opportunistic and value-add properties could be “appealing” in a higher interest rate environment, but he is quick to add these investments should be made on a case-by-case basis.

Instead, the best opportunity to generate consistent returns with reliable yield and growth will be a diversified approach to investments, such as a diversified income fund whose portfolio is divvied up among three different types of CRE investments: traded equity, real estate credit and direct real estate.

Crowe, it must be noted, manages just such a fund, but he makes his case well.

Traded equity, or publicly traded REITs offer higher levels of growth, liquidity and access to a more global opportunity set, he explains. Real estate credit can offer higher security and income and direct real estate offers higher levels of capital stability and attractive income.

But this three-pronged approach is not necessarily simple, Crowe continues—the allocation has to be just right in order to balance the upside against the downside.

“Real estate credit is potentially one of the most sensitive to interest rates due to the often fixed interest rate of these investments,” he says. “Reducing this risk requires larger allocations to floating rate debt and shorter durations to decrease interest rate sensitivity. Private real estate requires reduced exposure to non-traded REITs due to their heavy net lease exposure, which are long duration leases with little to no rental increases.

Instead, he says, a smart play would be to increase allocation to private equity real estate, which has a track record of rising rents and capital value growth in addition to moderate yield.

Publicly traded REITs should be used to hedge interest rates by investing in real estate companies that will benefit the most from a rising interest rate environment, such as hotels, residential, international, CBD office and industrial, he says. However, he also warns investors not to rely heavily on publicly traded REITs to deliver yield “as high yielding REITs can be very interest rate sensitive, due to both yield's surrogate nature and earnings growth's link to cost of capital.”