Fact vs Fiction: Real Estate & Interest Rates

When you email someone out of the office, generic response hits your inbox a millisecond later. That’s how it feels whenever the words real estate is mentioned among investors.

A “but what about interest rates!” autoreply happens every time. In today’s article, I’ll explain the interesting relationship between real estate and interest rates that every intelligent investor should know. Odds are, it’s not what you think.

How Real Estate Works

Most real estate use lease agreements with set rent over a set period. Anyone who’s lived in an apartment or rented a storage unit can relate. When interest rates rise as the landlord, at first everything seems fine. The mortgage is likely fixed rate, so that doesn’t change. Rents keep coming in. What’s the big deal?

Buyers of real estate face different circumstances. Their new mortgage is more expensive than yours, and so their profits from the same property are lower.

And then there are the improved alternatives. With higher interest rates, all kinds of bonds and other investments are more attractive than before. A property cash flowing 6% a year may look great compared to a Certificate of Deposit (CD) with a fixed-rate of 2% annually. That was math for much of the past decade.

But a more expensive mortgage causes the property’s cash flow to decline, all other things equal. If the buyer is lucky, it’ll now be 5% annually from that real estate versus an FDIC insured (up to a limit) CD also paying near 5%. Now, it’s not so easy of a decision which to invest in. That’s the current reality for many investors.

To make the risk worth the reward, buyers automatically ask for a lower price on real estate. And the more dramatic interest rates rise, the more of a discount they need. It’s like paying a discount for a fixed-coupon bond. The lower the price paid, the better the economics for the buyer.

So, it’s straight forward then. Higher rates equal lower real estate values. Not so fast.

Data Versus Theory

If all that is true, why did CoStar, a leading real estate data company, just report that U.S. single-family home prices reached their ninth all-time high with the past 12 months?

That’s the interest rate on the average 30-year U.S. mortgage going back to 2014. Mortgage rates certainly haven’t returned to previous lows. Far from it: they are near 10-year highs. Yet home prices keep hitting new records. How is this possible?  

I’ll walk you through what’s happening and why, as it applies to a lot more than single-family homes.

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REIT stands for Real Estate Investment Trust. They are publicly traded companies restricted to owning physical real estate (called equity REITs) or mortgages tied to real estate (mortgage REITs).

Since real estate is all one market and REITs own every type of real estate imaginable from movie theatres to cell towers to skyscrapers, they are a suitable proxy for the sector. For researchers and analysts like me, REITs are especially useful for data mining because all their key financial and operating information is shared publicly in regular SEC filings. That doesn’t apply to other types of real estate owners who don’t necessarily need to share any information publicly.

Over the 25-year period Standard & Poor’s selected (the same company that issues credit ratings), REITs outperformed the other major asset classes. But this 25-year timespan included not one, not two, but three serious inflationary periods – and all came with higher interest rates.

If higher rates were the death nail to real estate, it seems unlikely that REITs would have beaten all other major asset classes. Let’s investigate.

REIT performance historically beats the S&P 500 in both moderate and high inflationary periods (it slightly underperforms with low inflation). This chart gives us insight into why.

Notice how tall the “income returns” column in light blue is for REITs in the moderate and high inflationary periods. Real estate landlords have historically been able to pass on inflation to tenants with each new lease. For self-storage or apartments, every month is an opportunity to raise rents, so these property types potentially excel. For office and industrial, which have lease terms as long as 10 years, it can take years before the building owner can effectively raise rents. That’s why selecting the right type of real estate, or owning a broadly diversified basket, is ideal.

No matter the type of real estate, replacement cost goes up with inflation. That is another tailwind for real estate as the prices of labor, land, and construction materials generally rise. Imagine if you could build a vacation home using prices from the 1990s?  

Over many cycles, real estate has demonstrated the ability to absorb inflation than other asset classes primarily through higher rents charged to tenants. That’s helped make REITs the best performing major asset class, on average, in all the modern era inflationary environments.

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The rightmost column is the total return of REITs versus stocks. A positive figure means REITs outperformed stocks and vice versa. In the last six inflationary cycles going back to 1976, REITs did better than the S&P 500 in three periods (the 1970s, early 1980s, and mid-2000s), tied in one (late 1990s), and underperformed two (the mid-1980s and mid-1990s). Since the current episode is ongoing, it’s not included.

What’s most notable is the delta. In both the late 1970s and mid-2000s, REITs really outperformed stocks to the tune of 91.4% and 70.6%, respectively.

In the late 1970s, inflation was the highest in modern times. The Consumer Price Index (CPI), the benchmark for U.S. inflation, peaked at 14% in 1980. Interest rates rose to nearly 20%. Rising food and energy prices, coupled with a failing wage-price controls program by the Nixon administration are the most commonly cited drivers.

This period is described as “stagflation”, which is high inflation with low economic growth. High inflation benefited real estate and slower economic growth hurt stocks. That’s why most believe real estate did comparatively well.

In the mid-2000s, real estate far exceeded the return of stocks due to a combination of factors. Thanks to increased government subsidies of single-family and multifamily residential real estate loans, what many experts now consider an extended period of artificially low interest rates, plus the expansion and securitization of the mortgage market in general, real estate boomed. The excess didn’t last long as those who had real estate investments in 2008 and 2009 remember, although stocks and almost every other asset class had a severe downturn as well.

Takeaways

Real estate’s absolute and relative performance doesn’t have the one-to-one relationship with interest rates that many investors believe. The driver of the change in interest rates is key.

If the government is rapidly expanding the money supply and the economy is strong, both the value of the physical property and rents charged to tenants generally rise. That’s the case even if the Federal Reserve increases interest rates to try to cool the economy.

If the economy is on fire but inflation is low, real estate tends to do well, but not as well as a high-quality basket of stocks like the S&P 500. After all, real estate can’t triple in value rapidly like a fast-growing stock can.  

If economic growth and inflation are low, real estate might still be able to generate modest income to investors, but that’s about it. Appreciation and rent growth will be limited or non-existent and there will be better places to park your hard-earned dollars.

Keep in mind this is heavily based on historical data and the future is uncertain.

Today, inflation is still at 40-year highs. While no one can say for sure, it’s at least partially related to record federal budget deficits and total debt, a hangover from global COVID-19 spending, and a tight labor market in many developed nations like the U.S. Many of these variables don’t have a clear solution on the horizon.

Based on the last 70 years, income generating real estate isn’t as sensitive to higher rates as most people think. In fact, it outperformed almost all other asset classes during inflationary investments. But since every economic period is unique, it’s smart to consider other proven options, like stocks, to balance out a portfolio.

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Nothing in this blog is or should be construed as investment advice or an offer or solicitation of offers of investments. Both Real Estate Investments and Securities offerings are speculative and involve substantial risks. Risks include but are not limited to illiquidity, lack of diversification, complete loss of capital, default risk, and capital call risk. Investments may not achieve their objectives. Investors who cannot afford to lose their entire investment should not invest in such offerings. Consult with your legal and investment professionals prior to making any investment decisions. All Securities are offered through North Capital Private Securities, Member FINRA/SIPC.