Investors of retail properties ended 2018 with a lot of uncertainty. Heading into 2019 news channels were talking about an impeding recession that might correct a never-ending rise in property values. Was this the end of the longest real estate cycle of our generation?
After a brief reduction in transaction velocity in early 2019, the Federal Reserve made a move that would re-fuel consumer confidence resulting in an increase in transactions. In July 2019, the Federal Reserve cut the federal funds rate for the first time since it began quantitative easing in 2008. The federal Funds rate has continued to drop throughout 2019 and now sits at a surprising 1.75%. This gives retail owners and investors ample opportunity to continue making significant cash flow despite record real estate prices.
How Do Interest Rates Affect Property Values?
Interest rates have a profound effect other value of income-producing properties. They significantly affect the cost of capital which impacts the return an investor receives when purchasing investment real estate. The lower the interest rate retail investors obtain will help increase the amount of money they are willing to spend. A key benefit to investing in commercial real estate is the use of leverage.
Consider buying a stabilized retail property selling for a 6.50% cap rate when the interest rate on the loan is 4.50%. The difference between these two metrics generates a yield of 2.00%. There are other potential benefits of investing in retail properties that this 2.00% yield doesn’t measure, including property depreciation expense and a possible increase in the market value of the retail asset. Even without taking these factors into account, the 2.00% yield in this example is higher than the current 10-year treasury yield of 1.8%. If interest rates were to rise by 100 basis points, that would give a retail investor the same loan at a 5.00% rate. This would generate a 1.50% yield which is much less attractive than the previous situation. Once interest rates rise, retail investors will be less willing to pay the aggressive prices they are now and begin looking for properties with higher cap rates and larger spreads. This will affect the values of retail properties, causing owners to price their assets much less aggressive than they are able to now.
There are many questions that retail owners and investors are trying to find the answer to. How long will this economy last? When will we see a rise in interest rates? What will happen when a downturn in the economy finally arises? Nobody really knows for sure. Some of these worries seem to be a common trend toward the end of each year, yet, the economy continues to get stronger and stronger. Owners of retail centers have been working with Our team at Marcus and Millichap to understand how their centers are performing in the unique market we are in today. This has helped retail owners and investors prepare for any market shifts in the unforeseen future.