The Death of Rate-Induced Price Inflation

Interest rates reached their nadir in early May and are on the rise. Already at its highest level in two years, the benchmark ten-year Treasury is now moving towards 3.0 percent, more than double its all-time low. There's no surprise in the current trend; it was simply a question of when the unsustainable distortions would subside. For investors and their financiers, there are now two main issues: how far and how fast the rate environment will swing; and how the change will impact property investment.

Investors have been attributing the shift in the rate environment to updated language from the Federal Reserve. The central bank has been held to ransom by traders dealing out volatility in return for hints at monetary policy tapering. But actual rate outcomes have more to do with investors' expectations for monetary policy than the policies themselves. With sentiment changing abruptly, the rise in rates is out of proportion to the comparatively subtle shifts in Fed communication. In the absence of inflation, the underlying condition is an improving outlook for the economy — but not an outlook that approaches runaway growth.

What do higher rates mean for property investment when income gains offer an incomplete offset? In a leverage business, the cost of financing matters a great deal. Problems will arise where myopic return expectations depended on rates staying at impossibly low levels. At a minimum, even the most creditworthy investor can expect new mortgages will carry a higher price tag. That is not to say that cap rates will move in lockstep with risk-free yields; there's ample evidence they can move in different directions. But properties that have depended inordinately on cheap money for their value recovery will require stronger income growth as rate-induced pricing deflates.