It’s About to Get Real as Higher Rates Weigh on REITs

At least it’s not the ’80s, and not just because VHS tapes are inconvenient and low quality by modern standards.

Rather, interest on 30-year fixed-rate mortgages peaked at over 18% in 1981 and barely dipped below 10% during the full decade, which makes today’s rising loan rates seem downright cute. There’s more to the story than that, though. The Fed’s recent 0.25% rate hike, which brings the target rate to 3.75 to 4%, complicates things for real estate investment trusts and private real estate. In part, asset owners might be expecting less capital appreciation than in lower-rate environments, though they may be hoping for more income from their investments. But across the board, refinancing is getting both more cumbersome and more expensive.

“The effect is on the entire real-estate finance market itself,” said Dan Valenti, partner at Troutman Pepper Locke. “For our clients where real estate is all of what they do … they’re all feeling the same pressures from it.”

Re: Financing

Two metrics used in the real estate business — loan-to-value ratios and debt-service coverage ratios — affect the rates borrowers can get. Higher capitalization rates have notched up loan-to-value ratios, and consequently, borrowers may have to come to the table with more equity or collateral than they previously would have, Valenti said. And the larger amounts borrowers must spend on debt service can also trigger features in loan documents like access to cash, which may now be more restricted, he noted. “We have not just the [rate] increase now but signals that there may be another increase in the future,” he said. “People are cognizant of that and are pricing that in right now.”

For investors, it’s becoming more crucial to own the right types of properties, said David Lebovitz, head of alternatives investment strategy at JPMorgan Asset Management. Historically, if inflation and interest rate changes were even, real-estate investments generally saw higher income and capital appreciation over time, he noted. But inflation going down and interest rates going up is a ding on capital values, making income more important, he said. “We want to make sure that the assets are going to be able to grow their rental rate,” he said. “We’re not making big bets on a whole lot of capital appreciation.”

Some of the opportunities he said the company sees in real estate include:

• High-quality office space, retail and industrial complexes focused on things like advanced manufacturing.
• Higher demand for premium spaces, as office renters want features like tech-enabled meeting rooms and manufacturers need more sophisticated amenities than ever.

‘I Believe You Have My Stapler.’ Office space is getting harder for small- and medium-size businesses to secure as rents go up, but the higher prices don’t necessarily mean that vacancy rates will rise, Lebovitz said. Even though working from home remains common, more big companies (JPMorgan included) have employees back in the office five days a week, and they have the deep pockets to pay for premium spaces, which is important for the types of properties investors own. “It’s going to be a tale of two offices,” he said. “There has been a bifurcation in the way that different people work, and every single worker is not going to be in an office going forward.”