POTENTIAL IMPACT OF INTEREST RATE RISE SURFACING QUICKLY

June 3, 2013…..

Interest rates will be going up. The timing, duration, and magnitude of the increase is the only question. We have known this for some time, and the bond markets are finally yielding to the knowledge that the Fed cannot, and will not, “support” the market forever. Last month, particularly last week, were tough on bonds, and people holding fixed income investments saw entire years’ worth of interest payments wiped out by loss of principal due to rising rates. 

We have yet to see much panic over this rate increase, but there are ample signs that this time, we may be seeing a trend reversal. There are myriad potential impacts on the real estate market, and investors’ reactions the past few weeks may be tipping us off on what to expect in the foreseeable future.

As weak as the government bond market may suddenly appear, most major markets tied to it have fared much worse. For example, weeks ago, Apple floated a large debt offering which was easily absorbed by investors. Much of it is in IRA accounts and the like via mutual funds. The issue is now trading at 92, an 8 point loss (2 years’ worth of income) in less than three weeks. Lesser quality credits were hit much worse. Not only is there a change in attitude toward interest rate risk, but a change in attitude toward volatility (which has been absurdly low for years) and credit risk. This is not a surprise.

Most media focus has been on the rising residential mortgage rates, speculation on how long this will continue, and by how much. Little has been said about the area which may cause some turmoil in the future: the devastation in the stock prices and outlook for real estate investment trusts (REITs). This is a somewhat arcane subject, but a brief description may help you understand these potential impacts going forward.

REITs have become very popular fixed income investments in recent years. The company gets enormous tax benefits in exchange for passing on almost all earnings to investors. With interest rates so low and capital plentiful, investors have flocked to REITs and related instruments as a means of receiving higher yields on their portfolios. The effect has been rising prices for the companies, tightening spreads to Government bonds, and a general push to take the investor capital and “put it to use” as quickly as possible.

Because of this flood of investor money, issuer and investment banker push for upfront fee income on projects, and and the need to locate and either fund or develop new projects with that money, distortions have been developing in the real estate markets around the country. We have seen similar movies in the past.

One of the reasons for the dramatic rise in investment property prices over the past few years has been a lower assumed “hurdle rate”, or “cap rate”, which REITs and others are assigning to new projects. This is being justified by lower interest rates, implying a need for a much lower rate of return on projects than in the past to satisfy investors. The short of it is this: lower interest rates driving lower cap rates has a dramatic impact on what price the investor/developer is willing to pay. If rates move back up, particularly if the move is sharp and sudden, the entire dynamic of many projects/developments can change virtually overnight.

If the economics of projects changes, what will it mean for new development? Developments currently under construction? Recall my piece from two months ago, “A Rental Glut? This is a seller’s market, not a Landlord’s Market”. Nobody believed it then. We are seeing it play out now.

I will use the Reston Town Center as an example. Prices have been rising rapidly given a lack of homes and condos available for sale, combined with a strong buyer demand (much of that driven by very low interest rates). Meanwhile, rents have stopped rising, vacancies are developing, and the owner/landlords are having more difficulty renting individual units.

However, this is the tip of a potential iceberg. There is a major new rental hi-rise project on Reston Parkway at the Parc Reston site: under construction. The Avant in the middle of town is well under construction and scheduled for occupancy late in 2013. Vacant properties and the Spectrum project have a large “new rental housing” component to them. I fear these people are playing yesterday’s game, i.e., investor demand is for income-oriented projects, so therefore: build rental housing; allow the development in Reston to drive your project value up; provide adequate rental income for investors during the holding period; and convert to condominium ownership down the road as your “exit strategy”. All sounds logical, and things may work out that way. Or not.

A major player in the development and future development of the Reston Town Center is Boston Properties. The stock market ripped the stock of Boston Properties last week. Suddenly, investors want no part of a slightly-above 2% yield, especially when the company is paying out more in dividends than it is making in income. Higher overall market interest rates will likely have an exaggerated effect on this company stock moving forward, which will have a major impact on what projects in the “planning stage” actually get developed. The only investment advisory firms currently promoting this company as an investment are those with a large investment banking component to them. Yes, there is possibly a correlation there. 

But I am not “picking on” Boston Properties. I am merely giving a local example to what may be the fall-out from a major rise in interest rates, particularly if accompanied by a widening risk-spread investors place on private company debt versus Government debt. The devastation in REIT pricing hit virtually every company in the business, with mortgage REITs hit even harder than the property developer-types like Boston properties and Colonial Properties.

“So what?” you may ask. Here is the so what: a rise in interest rates is going to have a much more broad-scale impact on real estate markets than simply raising monthly mortgage payments for residential buyers using a 30-year fixed FHA loan, or equivalent. With rents already pushed to a somewhat-extreme range and much more supply coming to market soon, there is likely to be downward pressure on rents in the near term. This at a time when investor/developers may need to increase rents to justify investments made under assumptions of a lower hurdle rate.

If you are a “one off” individual owner currently renting a condo as an investment property, you may want to put pencil to paper at this point, and do further analysis. With prices rising for owner-occupied homes, you may consider being a seller rather than a landlord.

Call for further discussion on this complex topic.

Ray Wedell
Chartered Financial Analyst, CFA
RE/MAX Gateway
703-855-7299
RayMaxTeam@gmail.com
http://www.RayMaxInternational.com

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About RayWedellRealEstate

Real estate professional with Samson Properties. Chartered Financial Analyst, CFA
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