Interest Rates and Property Values
Is there a relationship between real estate yield and value? Please take a look at a previous post entitled Cash-On-Cash Return. Is there more to Real Estate Yield? In that post I suggested that the relationship was likely fairly slim. Real estate yields have little to do with value. But what about interest rates? Here, I would argue that the relationship is direct. Value is impacted by interest rates.
Not convinced? Let’s consider an example.
An investor is considering purchasing a property with a $3,500,000 asking price, and a Net Operating Income (“NOI”) of $200,000. The investor is seeking a loan amount the lower of 75% Loan to Value (“LTV”), or a 1.20 Debt Service Coverage (“DSC”), on a 30 year amortization.
A Full Loan Secured
In this example, at an interest rate of 4.00%, the investor could secure a 75% LTV, with a loan of $2,625,000. The DSC ratio is 1.34 times, so the loan amount was constrained by the LTV, and not the DSC. The buyer would need to invest equity of $875,000. The cap rate is 5.7%, and the Return on Equity (“ROE”) is 5.7%. So far so good.
But Interest Rates are Rising!
What happens if rates increase to 5.00%? The NOI and purchase price are the same, but the loan amount is now constrained by the DSC ratio, and not the LTV. To maintain a 1.20 times DSC ratio the loan amount would need to be reduced to $2,580,000, requiring the buyer to inject an additional $45,000. This is now a 73.7% LTV. The cap rate remains 5.7%, but the ROE is only 3.8%. All of a sudden, this isn’t looking like a great real estate investment.
The Buyer wants his Yield!
So what happens if the buyer approaches the seller and says they will go ahead, but only if they can get the 5.7% yield they was originally expecting? To achieve the 5.7% ROE, the purchase price would need to reduce to $3,200,000, with a resultant 75% loan of $2,400,000. This has the effect of raising the cap rate to 6.25%.
Would it be logical to assume that a buyer would request a loan reduction in the face of rising rates? The strategy of individual buyers will of course differ, depending upon a host of factors, many of which may be personal to the buyer themselves. I would however suggest that most sophisticated buyers have a “hurdle rate” for a cash-on-cash return expectation. Rising rates, as the example illustrates, do have a direct bearing on market values, and an overall reduction in prices, mirrored by an increase in cap rates, is not an unexpected byproduct of rising interest rates.