Investors continue to look for opportunities to put their dry powder into real estate. As an alternative to stocks and bonds, real estate is commonly viewed as a hedge against inflationary markets.
The Federal Reserve on Wednesday boosted interest rates by a quarter percentage point, leaving many landlords and real estate fund managers to wonder how the increase will affect their operations and bottom line. Fortunately, no one needs to ring the alarm. With the cost of capital remaining low, continued interest in real estate from both domestic and foreign investors, and robust demand for sectors such as housing and industrial, real estate should continue to see positive trends despite the near-term interest rate hike.
Additionally, the Fed is projected to institute up to three additional rate hikes of 25 basis points each throughout the remainder of 2022. Should inflation escalate, intervention by the central bank could become more aggressive.
Domestic and foreign investor interest nears record highs
Investors continue to look for opportunities to put their dry powder into real estate. As an alternative to stocks and bonds, real estate is commonly viewed as a hedge against inflationary markets such as the current environment, and fundraising efforts across the country have shown strong positive trends, despite the pandemic.
After a small dip in 2020, U.S. fundraising accelerated in 2021 to a twenty-year high of $120 billion, according to Preqin. Funds’ war chests are also at record levels, sitting at $225 billion at year-end. As interest rates rise, buyers may expand to tertiary markets as they look to acquire assets at targeted returns. Interest in U.S. real estate is vibrant around the globe, fostered in part by the volatile geopolitical environment. Foreign investors acquired over $70 billion in U.S. real estate in 2021, more than double the volume of foreign investment in 2020, and the highest since 2018, according to Real Capital Analytics. The momentum in foreign investment is not expected to slow down. With the instability in Europe due to the Russia-Ukraine conflict and the United States administering more vaccinations than almost any other country, foreign investors will fly to safety and continue to focus on the United States. A recent survey of overseas investors by the Association of Foreign Investors in Real Estate showed 75% of respondents are expecting to increase their holdings in U.S. real estate in the next three to five years, helping to keep the domestic property market in high demand.
Loan rates remain low
Once prospective buyers have their equity in line and have identified a property, they will often use debt to complete their capital stack. And this area of lending is where the Federal Reserve’s impending bump may have its most direct impact. Borrowers taking on short-term and/or floating rate financing will be most affected. They will want to evaluate their investment strategy and compare floating-rate debt to the cost of locking in a fixed-rate loan or purchasing an interest rate hedge. As nervous as investors may be about costs of financing, a 25-basis point rise in rates should not cause a major stir in the commercial mortgage market. In fact, recent analysis from Real Capital Analytics reflected that the spread between the 10-year treasury rate and mortgage rates would be more likely to compress, as the Fed reduces its balance sheet rather than result in a substantive increase in commercial mortgage rates.
Sector fundamentals are solid
Lastly, with the equity and debt markets remaining stable, many of the real estate property sectors also continue to show strong fundamentals. Across the four core sectors of multifamily, retail, industrial and office, cap rates have continued to compress over the last decade due to strong price growth and demand. Even if bond yields rise due to the Federal Reserve’s near-term rate decision, there is still plenty of room for further compression in the cap rates.
Looking into specific sectors, there is reason to expect optimism. In multifamily, the housing shortage continues to drive up apartment occupancy. The national vacancy rate sits at 4.9%, according to CoStar data; prior to declines in 2021, U.S. multifamily vacancy rates hovered between 6% and 7% for the last ten years. Meanwhile, the industrial market has reaped large dividends due to growth in e-commerce and demands by tenants to increase inventory amid supply chain disruption. The past twelve months have seen net absorption of over 500 million square feet of industrial space, CoStar data shows. By comparison, average industrial absorption over the past decade was only 215 million square feet. Even the office sector, beleaguered by pandemic-induced workplace shifts, shows opportunity as coronavirus cases decline and large companies such as Google and Meta plan office re-openings in the next month. As of March 3, Kastle Security System reported its highest occupancy rate in office buildings (38%) since the start of the pandemic. Despite uncertainty in the sector, U.S. office asset values have grown 10% in the past five years, according to CoStar. Across these various sectors, demand remains strong and investment prospects should stay favorable.
Increasing interest rates in the current inflationary market will leave investors and consumers across many industries concerned. For real estate, the impact should be muted. The fundraising and debt markets will keep the cost of capital low and affordable for future investment. Additionally, the fundamentals across real estate asset types remain strong. At a macro view, a 25-basis-point increase will be a blip on the radar for real estate owners and operators who can expect business to run as usual.