Will Values Fall If Rates Rise and Rents Don’t?

Fall 2013

This past spring, Joseph L. Pagliari Jr., clinical professor of real estate at the University of Chicago’s Booth School of Business, gave a presentation titled “Some Thoughts on Past and Future Real Estate Returns” to a NAIOP National Forum. Today, as interest rates appear to be rising, nervousness about rate increases and their impact on real estate values appears to be on the rise as well. Development recently caught up with Pagliari to ask about his outlook on interest rates, commercial real estate values, and what all this means for owners and investors.

Development: This seems to be a good time to look at the issue of how commercial real estate values have risen as a result of low interest rates rather than rent growth. If interest rates are rising, what is your forecast for the next six months regarding interest rates, cap rates (across all commercial property categories), and return expectations?

Pagliari: I’m not one to make short-term forecasts; there’s simply too much “noise” in such exercises to make the forecasts worthwhile. That said, there seems to be some initial evidence that commercial property prices have stalled. (See Green Street’s Commercial Property Price Index.) The popular conjecture — with which I largely agree — is that the stall in price growth reflects the market’s uneasiness over the path of future interest rates.

Development: You’ve offered some thought-provoking findings about real estate’s long-term correlation with inflation, when inflation is greater than average. Can you explain further?

Pagliari: Consider two regimes (or environments): one in which inflation is greater than its long-term average (about 3.9 percent per annum) and another in which inflation is lower than its long-term average. In the first regime (in periods of high inflation), real estate returns were about 76 percent correlated with changes in the consumer price index (CPI); (with inflation). In the second regime
(in periods of moderate inflation), real estate returns were lowly correlated (only about 30 percent) with changes in the CPI.

Combining the two periods, real estate returns were only about 42 percent correlated with inflation. While I did not separate the analysis by property type, the conventional wisdom is that apartments and hotels — with their short-term leases — are better positioned to capture unanticipated inflationary changes than property types with long-term leases (industrial, office, and retail) –– unless those properties have a CPI escalation clause built into existing leases.

Finally, there are essentially two components to real estate return’s ability to hedge inflation: 1) the extent to which net operating income (NOI) moves with inflation and 2) the pricing (that is, the capitalization rate) of future expected cash flows.

The former is largely influenced by the degree to which space markets operate in equilibrium. For example, landlords have pricing power when vacancies are low and tenants have it when vacancies are high. So, real estate’s ability to act as a hedge against unanticipated inflation via increases in future rents — once existing fixed-rate leases expire — is influenced by the supply and demand conditions for a particular property type. The latter is largely influenced by the capital market’s desire for real assets (commercial property, timber, agricultural land, precious metals, and so forth) — as opposed to financial assets — due to the market’s apprehension about unanticipated rates of future inflation.

chart showing real estate's correlation with Inflation

Development: In an analysis of rental rates by property type between 1987 and 2011, you show that only apartments beat inflation. Can you expand on some of the reasons why, and talk about if or how that might change for office, industrial, and retail property, going forward?

Pagliari: My conjuncture is that the apartment market has benefitted (some might say perversely so) from the not-in-my-backyard (NIMBY) attitude of many suburban municipalities with regard to apartment development, whereas the same municipalities display a yes-in-my-backyard (YIMBY) attitude with regard to the development of the other property types. This braking mechanism has historically curbed apartment development, which in turn keeps supply better matched (from an investor’s perspective) to demand. That, in turn, provides apartment owners with the opportunity to raise rents faster than owners of other property types. (This is essentially the same argument as above: low vacancies tilt the balance of power toward landlords and away from tenants.)

To provide the contra-example, suburban office buildings have been the worst-performing property type in the NCREIF index for roughly the last 35 years. This is not because of a lack of demand; there has been plenty of positive absorption. Rather, it is largely because supply grew too quickly. Part of the reason supply grew too quickly was and is the YIMBY attitude of municipalities with regard to suburban office buildings. (In such discussions, it often is helpful to separate investors from developers and brokers; what is good for one is not necessarily good for the other.)

While I do not see this environment substantially changing for industrial, office, and retail property anytime soon, I am concerned that urban municipalities also display a YIMBY attitude with regard to urban apartment developments. If so, then the braking mechanism described above is lost; in turn, this ultimately suggests less-favorable outcomes for urban apartment projects, all else being equal (though it almost never is).

Development: How should property owners and investors think about investment opportunities now? Is your “map” of low- versus high-barrier markets and properties changing?

Pagliari: Owners/investors ought to persistently monitor the capital market’s pricing of various markets. One popular dichotomy today is high- versus low-barrier markets (or, framed another way, coastal versus non-coastal markets). Other variations include primary versus secondary/tertiary markets, domestic versus foreign markets, and so forth. One market cannot always be better than the other, irrespective of price. So, investors need to think constructively about expected risk-adjusted returns. When they do this, the initial price (or cap rate) is just one factor in their considerations.

For long-term investors, I’d argue that two other significant factors are 1) the forecasted growth in future cash flows and 2) the volatility or riskiness of those cash flows. Investors need to form expectations about these two factors (in addition to the capital market pricing) for each of the markets under consideration.
These estimates/forecasts are constantly changing. So, investors need to be vigilant about how they allocate capital. However, on the private side of the commercial real estate business, transaction costs are high; consequently, portfolios should be rebalanced only when the expected improvement in risk-adjusted returns comfortably exceeds the rebalancing costs.

Moreover, the principles of portfolio management suggest that passive investors ought to consider the diversification benefits of having exposure in multiple markets. Active investors, on the other hand, may find that they can reap certain economies of scale when properties are near one another. This is a variation of the diversification-versus-focus argument in corporate investments.

As a general comment, the core funds have often found comfort in tilting toward coastal markets while the non-core funds have looked elsewhere for their risk-adjusted returns. Blackstone, for example, has prominently acquired assets in non-coastal markets of late.