A Rate Increase: Adversity or No Big Deal?

NEW YORK CITY—For nearly half of GlobeSt.com's 15-year history, the Federal Reserve has kept interest rates at historically low levels. Rates have been so low for so long that many commercial real estate veterans express concern about whether relative newcomers can compete in a higher-rate environment. And after months, even years of waiting for the other shoe to drop, the industry is now facing the increasingly likely prospect of a modest hike before 2015 ends.

How much of a concern a rate increase should be for the industry is a question that drew varying responses when GlobeSt.com polled members of its advisory board in connection with the site's 15th-anniversary celebration. Some board members expect a deep impact from that eventuality, while others are of the view that the industry will shrug it off.

Still others take a position that's somewhere in between, such as Sean O' Shea, managing director of the net lease group at BRC Advisors. “In fairness, these last few cycles have been extended and manipulated like never before,” he says. As a result, younger industry members' “lack of actual experience, combined with a lack of a sense of history, will conspire to ill equip them for the adversity that could be 'The REAL New Normal.' We'll see.”

Mark Rose, CEO at Avison Young, also takes a wait-and-see approach on the question. “First things first: they will rise,” he says. “They only have one way to go. But here is the rub: just because they rise, that doesn't mean it's a catastrophe.”

Rose thinks we can expect “one or two 1/4% increases between September 2015 and March 2016. That is healthy for the economy and the markets as we start to trend back to 'normal.'” Naturally, he adds, “if interest rates spike, that is a whole other story. The Fed will manage this properly and may even cut after they raise, depending on the state of the financial systems and the economy.”

Looking at the dovish position that the Fed and its Federal Open Market Committee have taken on interest rates, especially since the capital markets crisis of 2008, Rose calls it “the greatest gift to real estate. More than 40% of real estate investment returns over the past 15-plus years is directly attributable to declining interest rates. Very smart investors have been made to look even smarter by the FOMC. We are now judged as a real alternative asset, but are subject to volatility when interest rates rise. This dance isn't over, but we will see small rate increases” staring later this year.

Along with an increase in the cost of capital, an especially serious consideration for REITs, one of the chief bugbears of a rate increase is its effect on capitalization rates. Yet Jim Costello, SVP at Real Capital Analytics, takes the long view. “Interest rates have gone up before and the market has survived,” he says. “Every time since 1978 when interest rates go up, there is less than a one-to-one increase in cap rates. We'll survive this.”