For as long as the Federal Reserve has been buying mortgage backed securities and Treasury Bills, we have been warned that the end of Quantitative Easing (QE) will mark a rise in interest rates and a corresponding increase in Overall Capitalization Rates (OARs or Cap Rates). QE3 ended in October 2014 and many capital market observers expect the Fed to begin to increase the Fed Funds rate (and therefore all rates) in early 2015. We have yet to see an increase and rates are at or near historical lows.
Mathematically, an increase in cap rates would lead to a decrease in value, all things being equal. Think about the long-term leases with minimal or no rent increases. An increase from 6.50% to 7.00% on level income leads to a decline in value of 7%. Alternatively, income would need to increase 7.7% in order to maintain the same value with an increase of 6.50% to 7.00%. Your long-term Net Leased assets, the best of which have 10% rent increases every five years and the worst are flat for 20 years, are most susceptible to overall rate increases.
Some advisors have speculated that it is time to shift from these net leased assets to properties that are actively managed or can be repositioned to take advantage of rising market fundamentals (rent increases and higher occupancy). However, the "coupon clippers" have become so attractive in recent years in large part because of the ease of management, relatively low risk of tenant default, improvements that are recently built and have excellent locations. It is also true that the market has known of the potential for increasing interest rates and the end of the bond buyback program for a long time, so it is hard to imagine that these investors did not price this risk into their purchases or investment strategy. If rates rise too much, investors that need to sell an asset in an increasing cap rate climate could be hurt. I suspect that if rates do increase substantially that we will simply see fewer re-sale transactions. On the development side, it may result in the negotiation of higher rental rate increases throughout the term, so as to make it more palatable to develop Net Leased Assets. However, in order to increase rental rates for new deals, development would only occur if tenants can afford a higher rental rate.
Do you have a different take?
Mathematically, an increase in cap rates would lead to a decrease in value, all things being equal. Think about the long-term leases with minimal or no rent increases. An increase from 6.50% to 7.00% on level income leads to a decline in value of 7%. Alternatively, income would need to increase 7.7% in order to maintain the same value with an increase of 6.50% to 7.00%. Your long-term Net Leased assets, the best of which have 10% rent increases every five years and the worst are flat for 20 years, are most susceptible to overall rate increases.
Some advisors have speculated that it is time to shift from these net leased assets to properties that are actively managed or can be repositioned to take advantage of rising market fundamentals (rent increases and higher occupancy). However, the "coupon clippers" have become so attractive in recent years in large part because of the ease of management, relatively low risk of tenant default, improvements that are recently built and have excellent locations. It is also true that the market has known of the potential for increasing interest rates and the end of the bond buyback program for a long time, so it is hard to imagine that these investors did not price this risk into their purchases or investment strategy. If rates rise too much, investors that need to sell an asset in an increasing cap rate climate could be hurt. I suspect that if rates do increase substantially that we will simply see fewer re-sale transactions. On the development side, it may result in the negotiation of higher rental rate increases throughout the term, so as to make it more palatable to develop Net Leased Assets. However, in order to increase rental rates for new deals, development would only occur if tenants can afford a higher rental rate.
Do you have a different take?
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