Will Higher Interest Rates Crush Real Estate?

Real estate has been a solid performer over the past several years. For instance, the Wilshire U.S. Real Estate Investment Trust Price Index — a measure of the price performance of real estate investment trusts (REITs) — has jumped nearly 15% over the past year and about 50% since the beginning of 2011. These growth rates were driven largely by the improving economy and sustained low interest rates.

The big question on investors’ minds is: When the Federal Reserve inevitably hikes interest rates, how will it affect the real estate market?

Hiking Rates

The Federal Reserve has kept its benchmark interest rate near zero since the 2008 economic crisis, but recently, it has begun preparing the financial markets and consumers for a return to normal interest rates. While many economists believe it’s unlikely the central bank will act until September, it left open the possibility of hiking rates as early as June in its most recent meeting. (For more, see: The Impact of Interest Rates on Real Estate Investment Trusts.)

There’s no doubt that higher interest rates will damage real estate investments, given that almost all real estate relies on financing costs. In fact, many real estate indexes have already trended lower over the past month amid speculation that the central bank would act to increase interest rates. The weakness in the economy has helped form a base, however, since interest rates won’t rise quite yet.

Potential Offsets

When interest rates are eventually hiked, the upshot is that other factors could help offset the impact. The constriction of new developments and the transfer of supply/demand dynamics in favor of current landlords, for example, could help boost real estate net operating income and valuations over the long-term, provided they have stable financing in place to ensure long-term project viability. (For more, see: 4 Key Factors that Drive the Real Estate Market.)

Occupancy rates at many REITs aren’t necessarily oversupplied either, which could amplify these effects. According to a recent Citigroup report, Q4 2014 occupancy rates across all REIT sectors stood at a record high 94.5%. Many experts believe that these occupancy rates could become a major driver of income and valuation when interest rates rise and constrict the ability to increase the supply side. (For more, see: Invest in REITs with This ETF.)

Other Considerations

The catch is that not all REITs are created equally and it’s important for investors to differentiate between the sector’s performers. For instance, residential property and healthcare REITs were top performers that generated more than 30% returns in 2014, while free-standing retail and timber REITs came in with returns below 10% over the same period — a significant difference by anyone’s measure. (For more, see: How Interest Rates Affect Property Values.)

Investors may also want to shift their mindset to view REITs as long-term income investments, designed to replace record-low bond yields as a way to generate some retirement income. In these cases, the potential for capital gains should be weighed against the reliability of the income when determining what REITs or REIT sectors may be the best investments for individuals or funds. (For more, see: The Tangled Web of Interest Rates, Mortgage Rates, and the Economy.)

The Bottom Line

The Federal Reserve isn’t likely to raise interest rates until at least September, but real estate investors shouldn’t ignore the pending risk. While higher rates will likely hurt the sector in the short-term, the long-term economics remain very compelling when looking at things like occupancy rates. But, investors should consider what REIT sectors represent the best opportunities for their situations. (For more, see: Simple Ways to Invest in Real Estate.)