The real estate industry is entering a new season. As the weather warms up, the flowers bloom and the patios open, real estate investors in North America have to contend with rising interest rates. While often discussed, the rubber has hit the road and the unique period of super low interest rates appears to finally be over.
This new higher rate phase will affect investment performance, capital projects and acquisitions. In this blog, we make a high level impact assessment of this new era of higher interest rates and the impact on acquisitions.
Of course, the reason for the rate increase is well understood. The powers inside the Fed and the Bank of Canada, need to put the brakes on the massive price inflation that has resulted from supply chain shortages, huge demand for goods and services and very low unemployment.
However, this was a very telegraphed increase and the real estate industry was prepared for the rate increase that occurred on April 13th here in Canada. This is evident in the public market’s reaction in Canada as observed in the TSX S&P REIT index The chart below shows that there was no significant drop in price after the announcement by the Bank of Canada. This level-headed reaction signals that investors are not expecting the REITS to face any significant shock to their finances either due to mark-to-market impacts on their mortgage payments or any near-term disruption to their rental income. So, as investors look to the public markets for a leading indicator on investment performance of commercial real estate, the initial impact of a rate increase seems to have been minimized.
But what about acquisition teams, how will this increasing rate environment affect these groups who are under pressure to close deals? Specifically, they now have to contend with a market where financing is more expensive. Yet, asset prices are still at all-time highs. Also, price inflation has put a dent in plans to refurbish older assets due to the fact that labour is scarce, construction materials are more costly than ever and there are many well-financed investors seeking assets.
Now, focusing on the acquisition teams. These teams are going to have to adjust components of their deal models.
The first impact will be on the acquisition model’s cost of debt servicing. The additional dollars needed to support the debt payments, specifically if a short term variable mortgage is used, will be significant. As most mortgages are set at a five year term but most assets are owned for longer than five years, it will be imperative to adapt the underwriting model to account for the fact that future interest rates will be higher. This will hurt exit yields and annual yields.
Secondly, the loan balance carried on the income statement of the property will take longer to draw down since mortgage payments are going to be higher. So while this might not make a huge dent in the yield of the property, it will raise questions about the carrying cost of the asset, especially if income that the property generates doesn’t increase as expected.
So, while it is understood that the costs of carrying property is going to be higher due to rates, it is important to note that the higher costs make it more difficult to reach a hurdle rate target for investor returns. This results in it taking longer for the hurdles to be achieved or longer periods of carried interest having to be paid to investors.
Of course, there is the risk that these newly acquired assets end up losing value if rates rocket skyward and we see the denominator effect wiping out any capital gains through lower valuations. It must be acknowledged that real estate investors have done incredibly well over the past era, benefiting from a resilient asset class, pricing going higher in most sectors and rental income growing. But it is a cyclical asset class and the industry has seen periods of asset value destruction. This is a worst case scenario, i.e. rising rates, costs and decreasing asset values.
Finally, the acquisition teams will be dealing with more questions about the impact of higher rates on their deal model. This will result in delays in making decisions and more scrutiny than ever on the economics of buying an asset. Regardless of the record amounts of investor capital that is on the sidelines, this new uncertainty might force the acquisitions teams to hit the “pass” button more often than we have seen over the past few years.
So, as we enjoy the lovely spring weather, it is not just rising temperatures but also rising rates that are going to be actively discussed. It appears that the acquisition teams will be busy as bees this spring!