It might seem odd to be going back to the topic of increasing interest rates and the potential effects on commercial real estate prices given the turmoil in the capital markets and the fact that the Chinese have just cut interest rates. But, for those interested in how rising interest rates might affect commercial real estate markets and prices, I’ve come across two pieces of empirical analysis – by well-respected analysts – Jack Corgel at Cornell and Serguei Chervachidze of CBRE. Both argue that the effects of interest rate rises will be negative – falling prices (rising cap rates). However, both hedge their bets somewhat and probably rightly so. The standard theoretical models of capitalization rates (yields) are founded upon the Gordon Growth Model
Cap Rate = Nominal risk-free rate + Risk premium – Income growth
The nominal risk-free rate represents the real rate of return plus a rate representing inflation expectations. It is usually measured through a government bond benchmark. The risk premium is conventionally specified as the spread between a risky asset target rate of return and the government bond rate. Income growth is the growth rate in income from either growth in rents or Net Operating Income. So if government bond rates of return go up (as they are expected to if interest rates are increased), then all else staying the same, real estate yields will go up (and values will fall). However, if interest rates are rising because the macro-economic, real estate and capital market situation appear more favourable i.e. the risk premium is lower and expected income growth is higher, then the potential negative effects of interest rises may be muted. Perhaps this isn’t particularly good timing to be discussing interest rates rises given the current volatility in the capital markets.