By The Third Avenue Real Estate Value Team
Excerpted From the Third Avenue Real Estate Value Fund First Quarter 2013 Shareholder Letter
A frequently asked question and topic of discussion among Third Avenue Management investment professionals is what impact rising interest rates would have on our investments and our portfolios in general. While trying to tackle this topic, as it relates to global real estate, in a single essay is a daunting task, we will attempt to explain our view on how rising interest rates might impact the global real estate markets and how some types of companies might perform in such an environment. In short, it is our view that rising interest rates would likely create some volatility in the short term (which is the friend of the value investor); but, over the long term (which is where our focus ultimately lies), could ultimately benefit certain types of companies.
The big question: How will rising interest rates impact real estate values? Our answer: It depends. In fact, the impact on property values will vary greatly depending on (i) why interest rates are rising and (ii) what type of property one is talking about. If long-term interest rates spike materially due to some sort of economic crisis (e.g., a U.S. Treasury default), we have no specific opinion on the impact to real estate values (other than "it will probably be bad for most investments, real estate or otherwise – but, at least we own hard assets"). However, in a scenario where more vibrant economic growth in the U.S. leads to a falling unemployment rate, the Fed has explicitly stated it will increase short-term rates and is likely to take its foot off the gas as it relates to buying on the long-end of the curve. A vibrant economy and rising employment will likely be inflationary, leading to higher interest rates.
Commercial properties (retail, office, apartments, industrial, etc.) are primarily valued based on applying cap rates (i.e. initial yields) to property cash flows. Cap rates have historically been highly correlated to long-term interest rates, with the highest correlation being Baa corporate bond yields (as opposed to 10-year Treasuries). Based on history, it is reasonable to assume that an increase in 10-year Treasury yields will result in an increase in Baa corporate bond yields, but not necessarily on a one-to-one basis. In fact, credit spreads (the spread between Baa bond yields and the "10-Year") have historically tightened during periods of rising 10-year treasury rates. What does that mean? Simply put: if the 10-Year rates increase in response to economic growth, we would also expect Baa corporate bond yields and cap rates to increase, but at a more muted pace due to tighter credit spreads. Higher cap rates translate into lower property values, all else being equal. But, all else isn't equal. The second part of the answer to the big question is that the impact of rising interest rates depends on the property type, location and tenant lease terms. In order for property values to not decline, higher cap rates need to be offset by increased cash flow. For example, a property that generates $12 million of cash flow would be valued at $200 million using a 6.0% cap rate. At a 6.5% cap rate, the value would be only $184.6 million – a 7.7% decrease. The property would have to generate an additional $1 million of cash flow (an 8.3% increase) to offset the impact of the higher cap rate. The impact of leverage further magnifies higher cap rates. For instance, if the property was 50% leveraged with a mortgage, the 7.7% decrease in property value would result in 15.4% decrease in equity (or net asset value). The ability of commercial property owners to increase cash flow through rental increases depends on the length of lease terms for tenants in place, near-term lease expirations/renewals and current occupancy levels.
Property types with shorter lease terms, such as hotels (daily leases), apartments (annual leases), or industrial and retail properties (five-year leases) should fare the best over the medium term, as these property types are more likely to be able to increase rental rates, offset higher cap rates and keep pace with, if not exceed, the rate of inflation. On the other end of the spectrum, properties that are fully occupied by tenants with long term leases (e.g., office buildings) are likely to underperform in a rising interest rate environment. It may prove very challenging to increase rental rates at a fully-occupied office building with 10-15 year leases in place. This is a somewhat contrarian view, as these types of properties have been very popular in recent years and have been bid up in price based on their stable, long-term contractual cash flows. On average, U.S. REIT stocks are trading at record low dividend yields of 3.4%. While the yield seems attractive relative to other investment alternatives, an increase in interest rates (without a corresponding increase in dividend payouts) could materially impact REIT share prices. Since 1994, REIT dividend yields have averaged 120 basis points over the 10-year Treasury. Similar to Baa corporate bond yields, the spread is wider today (approximately 140 basis points) due to the Fed's initiatives. Should the 10-year yield increase to 3%, REIT dividend yields would likely need to increase to 4.2% (assuming the spread tightens to 120 basis points). In order for REIT dividend yields to increase to 4.2%, dividend payouts would need to increase by 23.5% from current levels (not likely in our opinion) or REIT share prices need to decline by 19%. The outcome is likely some combination of both.