How do interest rates affect real estate values?

Let’s start with the elephant in the room. The real estate market is crazy right now. Part of the reason why is rising interest rates.

In some ways, the inflation that rising rates portend is a debtor’s natural ally, because it amplifies returns on appreciation.

But it also has a complicated relationship with acquisitions. Today, we’re going to explain it.

How does valuation work?

Valuation is hard. Getting it right is arguably the most important differentiator between successful and unsuccessful strategies. Of course, most investors (at least implicitly) pick an acquisitions approach from the outset: a fund might prioritize acquiring particular kinds of assets as part of a tight investment thesis, which necessarily has valuation ramifications. If you want to buy tomatoes, it’s going to take a fairly tempting cantaloupe to migrate your capital elsewhere.

But within a given market, valuation is pretty much just a function of supply and demand. That’s especially true in relatively stable markets run mostly by established players.

Supply depends on lots of inputs: geography, construction costs, the local economy, turnover rates, and myriad other complex — and sometimes unpredictable — forces.

Demand is a bit simpler, because it basically comes down to two questions.

1. What cap rate applies?
2. How aggressive can we go on cap rate?

The first question is pretty much a mathematically sophisticated guessing game. As we’ve said before, cap rates are an interesting bit of two-way algebra.

On the one hand, figuring out what cap rate applies is pretty simple: just compare the past few years’ revenue with the proposed purchase price. If a property has historically yielded $80,000 NOI, and the proposed price is $1 million, it’s got an 8% cap rate. The nice thing about that approach is that it starts with hard, empirical data: how much money does this thing make?

But the proposed price is prospective, not retrospective. It’s more or less pulled out of thin air. And when a buyer and seller agree on an actual price, they have effectively agreed on the property’s cap rate. So here’s another way of looking at the same situation: paying $1 million for a property that’s expected to yield $80,000 annually means believing that it’s an 8%-cap property.

The bottom line: Picking a sale price in order to figure out a property’s cap rate is conceptually backwards. It’s putting the cart before the horse.

What investors making valuations calls are actually doing is deciding the property’s cap rate, and then making an appropriate offer.

That fact raises the all-important question: how do you figure out the right cap rate? If the answer is “look at the price,” then the whole process is a great illustration of circular reasoning — and not much else. Fortunately, that’s not the answer.

Instead, a property’s cap rate is a reflection of how risky investors think it is. Since a property’s cap rate is also a proxy for its expected profitability, the cap rate investors demand — which, remember, they establish when they agree on a price — depends on two things.

1. The risk-free rate. That number is tied to the economy as a whole — not any particular property. Typically, it’s defined as the expected return you can get on Treasury Bonds. For any investment you make, you could alternatively have put the same money into T-Bonds, which are basically the lowest-risk investment there is. So any other (riskier) investment that yields less than T-Bonds is a non-starter.
2. A risk premium. Not every investment that yields more than T-Bonds is worth it. If an investment yields only 1% more, but comes with a 50% chance that you lose everything, you’ll steer clear. Whether an investment is worthwhile depends on whether the prospective return outweighs the presumed risk. So the risk premium assigned to any given property = the amount of extra yield (on top of the risk-free rate) that investors require to offset the additional risk they incur by purchasing that property instead of T-Bonds.

So where does that leave us? Right here: a property’s cap rate, minus the risk-free rate, equals the value of the extra risk to which it exposes investors.

How do interest rates play into this?

You’ve probably already guessed the first way: interest rates are tied to the risk-free rate. As commercial rates change, so does the risk-free rate. Here’s how that works. And here’s a summary:

• As interest rates rise, many investors can expect better returns on their investments.
• So, their demand for bonds falls.
• So, bond prices fall.
• And as bond prices fall, bond yields go up.

Yep, bond prices and bond yields are (typically) inversely related. (Which makes sense: as demand for bonds falls, issuers have to boost their yields to attract investors.)

But when yields increase, so does the risk-free rate. And when the risk-free rate rises, assuming the risk premium remains constant, so do cap rates. And when cap rates are higher, assuming NOI remains constant, prices fall.

The bottom line: when interest rates rise, prices (should) fall.

Okay, but you said earlier that valuation involves two questions.

Right you are, dear reader. Here are those questions again:

• What cap rate applies?
• How aggressive can we go on cap rate?

Question two is where things get really interesting. After all, it’s basically the question buyers have to answer. There are a few considerations here.

First, consider the risk-free rate.

As the risk-free rate rises, cap rates rise too. In other words, investors demand higher absolute returns to compensate for forgone alternatives (sweet, sweet low-risk bond yields). So rising interest rates might incline investors to be more conservative about cap rates. And that, in turn, means falling property values.

Second, consider capital costs.

This discussion, so far, has been pretty theoretical. But rising interest rates come with an imminent, real-world cost: money costs more. For investors looking to lever up and buy some property, that cost factors into the acquisition analysis. As buying property gets more expensive, investors will price interest into their acquisitions theories.

In other words: same building + higher price = more reluctant buyers.

And, because taking on debt is risky, more debt means every asset’s risk premium will rise. That, too, suggests falling property values.

But there’s another elephant in the room: liquidity.

In practice, few investors are content to rake in (comparatively) meager returns on very low-risk investments. So when a wide variety of asset classes tank — as in a serious recession — investors don’t just liquidate. Yes, many investors will pull their money out of (perceived) traps. But they won’t stuff it into a mattress. Instead, that money will be looking for a home.

And when liquidity is high enough, demand for relatively low-risk assets, like real estate, stays strong. That’s part of the reason cap rates have historically continued to fall even during downturns. And it might suggest that investors fleeing struggling investments are willing to stomach more risk, and consequently take a more aggressive stance on cap rates. If that happens, values could stay constant — or, in some markets, continue to rise — even during a recession.

Where does that leave us?

The conventional wisdom: rising rates means falling property values. It’s true that falling rates does not necessarily mean falling cap rates. Like we’ve said before, cap rates have been slowly but surely falling for quite some time — no matter what the market does.

But it’s worth pointing out that cap rates and valuations aren’t necessarily all that strictly related. Cap rate is a proxy for valuation, but one assumption we’ve carried through this whole exercise is that little clause we hide between some commas in the middle of the big-reveal sentence: “assuming X stays the same.” But if X is NOI, then it almost certainly will not stay the same in the kind of inflationary environment that gives us rising interest rates. That’s especially true for properties operating on long-term leases, but it still impacts residential investors. In a recessionary atmosphere, costs usually go up faster than owners can adjust rents. When NOI falls, the cap rate equation is no longer just about valuations.

And, since recessions invite risk in myriad forms, it’s also worth pointing out that real estate investing isn’t exactly a closed system. Local market conditions — like the health of businesses that support local real estate by leasing storefronts and cutting employees’ checks — also play a part in real estate investors’ risk calculations.

The bottom line there is this: cap rates can keep falling even if values are falling, too. That’s because if values fall, but NOI falls more, cap rates will continue to compress. So although the cap-rate discussion is illuminating, it doesn’t tell investors everything they need to know about how to value property.