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Real Estate Investments and the Eventual Rise in Interest Rates

May 4, 2015

Investors have become accustomed to the Federal Reserve’s routine. “Coming Soon! A Rise In Interest Rates…But Not Too Soon!”

Whenever the Fed meets, analysts parse the words of Fed Chair Janet Yellen and speculate on when benchmark interest rates will rise from the 0.25% range in effect since late 2008. The stock market goes into a minor convulsion and things settle back to normal—whatever normal means in today’s economy.

However, eventually the interest rate tease will be over and rates will rise. When that day comes, what will be the effect on real estate investments? That’s harder to predict than usual because in some ways we are in uncharted economic territory.

For example, in typical economic times REITs can suffer with a rise in interest rates because investors can look at bonds as an attractive and less volatile alternative to REIT dividends. However, the Fed’s bond buying program and similar efforts worldwide have left the bond market so distorted that bonds are unlikely to be a sound alternative—even after a rate increase. REIT’s had the highest return of any 2014 asset class, and the largest blip was from nervous investors pulling out in September assuming an imminent rate hike.

For residential and commercial investments, the usual concern is that interest rates can rise so fast that rents can’t be reasonably raised enough to compensate. Rising rates usually occur to keep the economy from overheating, but in our current slow growth period the market likely can’t handle compensatory rental rates.

Consider that real estate is usually considered a hedge against inflation—but inflation is still well below the Fed’s goals and an interest rate hike certainly won’t drive inflation higher.

All indications are that the first interest rate rise will be relatively small and interest rates will rise slowly. Yellen reinforced this in a recent speech in San Francisco, pointing out that raising rates too quickly takes away the Fed’s ability to act if the economy fades again.

Barring a psychological overreaction to the first interest rate rise, the short-term effect will probably be minimal. The Fed lowered their estimate of December 2015 rates to 0.625%; bond futures suggest a 0.5% rate. By December the strength of the economy and the bond market may have returned to normality, and typical rules may apply as we head into 2016.

While interest rates do have an impact on private money lending, it is not as dramatic an impact as it is for conventional lenders who are very interest rate sensitive.  Here at Val-Chris Investments, we continue to believe the interest rate rise will be slow and steady over the next five years, and while interest rates in the private money lending world are still very attractive, we see only slight upward pressure on rates over the next 12 months.  Please let us know your thoughts on the movement of interest rates.