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What will rising interest rates do to commercial real estate values? I asked a similar question about home prices a few months back. Now with the run-up in interest rates on commercial mortgages, and my forecast that long-term interest rates will continue to rise, it's time to wonder whether non-residential real estate will suffer from higher interest rates.

A drop in commercial property values is not baked in the cake if interest rates rise. In economic jargon, you must worry if you do partial equilibrium analysis; you worry less if you do general equilibrium analysis. The English translation: If I look at interest rates as magically set by a fairy living outside the economic system, then I worry. However, if I recognize that interest rates are part of the economic system, I am less worried.

(click to enlarge)

Take a look at the table. I looked for periods in which the 10-year Treasury interest rate rose by at least one percentage point, over a period of at least one year. I then display real estate investment returns. The NCREIF returns include operating income, with prices based on appraisals. The NAREIT data show the price returns (exclusive of operating incomes) for Real Estate Investment Trusts. The NCREIF data are not ideal in that they are based on appraisals rather than actual transactions, and they include operating income in addition to price changes. The NAREIT data are not ideal because REITs sometimes move more with the stock market than with the underlying property values. Nonetheless, the two together give us a couple of views of investment real estate—and they are what we've got in the way of data.

To understand the NCREIF data, consider that operating income probably runs about seven percent—plus or minus a couple of percent—of property value. That episode in the mid-1990s when the annualized return was 6.8 percent could well have been a small negative for prices. The NAREIT data are not so favorable, with three episodes of falling prices, though we are not positive that these data reflect underlying property values.

Now let's explain the economics of property values and interest rates. The partial equilibrium analysis looks at interest rates as an outside ("exogenous" in our jargon) influence on property values. It's a logical starting point. The value of any investment asset (real estate property, share of stock, or bond) is the sum of the future stream of cash flow, discounted by the interest rate. With higher interest rates, the discounting reduces the present value of those future income streams. A simpler way to think of it is that at higher interest rates, investors are less likely to see a property's cash-on-cash return as justifying the investment.

How can this logic be wrong? Why doesn't the table show clear real estate losses when interest rates rise? Interest rates on mortgages, bonds, and other long-term debt are not set by the whims of fairies. They are determined by two factors: inflation expectations and economic growth, which combine to set the supply and demand for credit. Interest rates only rise when the economy is strong or inflation is accelerating (and inflation is most likely to accelerate when the economy is strong). At these times, investors are confident. Their animal spirits are up. They borrow more because prospects for investments look good. The factors that push interest rates up are the same factors that push up investment values. Interest rates rise because of strong investment demand.

What role does the Federal Reserve play in long-term interest rates? Not much. Although the Fed can move short-term rates here in the United States pretty much wherever they want them to be, long-term interest rates are set in global markets. When investors around the world are optimistic and want to borrow, and consumers are optimistic and save less, there isn't anything that the Fed can do to prevent long-term interest rates from rising.

Will commercial property values respond to interest rates in the future as they have in the past? The world is increasingly global. It's possible that global demand for credit would be strong even though one country's economy is soft. If we are an island of weak economics in a sea of economic strength, then we could see real estate prices go down with higher interest rates. However, it's even more likely that global economic strength would lead to domestic economic strength, pushing property values prices up. (Although I'm thinking of the United States as the domestic market, this analysis works even better for smaller countries.)

The answer to our question is not crystal clear. This time round rising rates could push commercial real estate in either direction. Let me put my conclusion in terms of asset allocation, assuming that long-term interest rates will continue to rise over the next two years. If I were heavy in my allocation to real estate, I'd look to reduce my exposure to the sector. If I were light in my allocation, I would probably drag my heels a little adding to my allocation. If I owned very little commercial real estate, I would certainly buy real estate for its diversification benefits.

Disclosure: I own several REITs and a REIT index fund.

Source: Commercial Property Values With Rising Interest Rates