TIAA-CREF Asset Management

Documeent title on one or two Cap rates rising: lines in Gustan Book 24pt Fear and loathing in real estate
TIAA-CREF Global Real Estate Strategy & Research
Martha Peyton, Ph.D. Managing Director Edward F. Pierzak, Ph.D. Managing Director

U.S. interest rates are astoundingly low and have been for quite a long time. But, it cant last forever and investors are worried. Their fears are rooted in the perception that rising interest rates will cause capitalization (cap) rates to rise and thereby weaken property values and commercial real estate investment performance. While seemingly a matter of straightforward arithmetic, we believe these worries are overblown because they ignore variables that have the potential to offset value declines. In fact, there are a number of factors that may provide protection to overall property performance in a rising interest rate environment. This paper examines the relationship between interest and cap rates and the overlooked factors that should soothe investor fears. While there is no guarantee that everything will turn out alright in the end, our short scenario analysis shows that catastrophe is unlikely.

Up, up, and away?

The potential for rising interest rates has provoked considerable discussion among real estate professionals. Specifically, investors worry about the impact of rising interest rates on property cap rates and valuations. These fears tend to focus on the arithmetic showing that rising interest rates result in increasing cap rates and, all else equal, declining property values. Exhibit 1 focuses on the relationship between interest rates and cap rates, with a display of NCREIF Property Index (NPI) transaction cap rates and US 10-year Treasury yields using data for the past 20 years. A rough positive relationship is evident between the two variables as demonstrated by the black line imposed on the scatter.

Exhibit 1
NPI transaction cap rate and U.S. 10-year Treasury yields (1Q93 to 4Q12)
12 11 NPI cap rate (%) 10 9 8 7 6 5 4
0 2 4 6 10-year Treasury yield (%) 8 10

Source: Moodys Analytics; NCREIF, as of 4th Quarter 2012; TIAA-CREF

Cap rates rising: Fear and loathing in real estate

But, that rough relationship does not mean that cap rates change in lock step with Treasury yields. The correlation between the two variables is not a perfect 1.0, but rather a moderate 0.6. More importantly, historical data show that changes in Treasury yields do not necessarily result in changes in cap rates. Our analysis finds no statistically significant effect of Treasury rate changes on cap rates.1 These findings confirm that cap rates are influenced by a wider network of variables beyond interest rates. They include real estate fundamentals, capital flows, and investor risk appetite.2

In todays environment, the most important factor that is overlooked is that interest rate increases are anticipated to coincide with strengthening economic and employment conditions. Consensus expectations from the Blue Chip Economic Indicators shown in Exhibit 3 confirm this.

Exhibit 3
Consensus expectations (%) Average Average 2015- 20202013 2014 2015 2016 2017 2018 2019 2019 2024 Real GDP Unemployment rate 10-Year Treasury yield Consumer Price Index 2.1 7.7 2.1 1.9 2.7 7.2 2.7 2.1 3.1 6.7 3.4 2.3 2.9 6.3 4.1 2.4 2.8 6.0 4.5 2.4 2.7 5.7 4.7 2.4 2.6 5.6 4.7 2.4 2.8 6.1 4.3 2.4 2.5 5.6 4.7 2.3

Spreads matter
In practical terms, the difference, or spread, between cap rates and 10-year Treasury yields is typically sizable and has the potential to act as a buffer that can absorb increases in the 10-year Treasury yield without corresponding increases in the cap rate. Exhibit 2 displays spreads between NPI transaction cap rates and 10-year Treasury yields from 1Q93 to 4Q12.3

Exhibit 2
NPI transaction cap rate spreads (1Q93 to 4Q12)
6% 5 4 3 2 1 0 1Q93 1Q94 1Q95 1Q96 1Q97 1Q98 1Q99 1Q00 1Q01 1Q02 1Q03 1Q04 1Q05 1Q06 1Q07 1Q08 1Q09 1Q10 1Q11 1Q12

Source: Blue Chip Economic Indicators, March 10, 2013 and April 10, 2013

Cap rate spread

20-year average

Real GDP growth is expected to strengthen from an anemic 2.1% in 2013 to a more robust 2.7% in 2014 and to an intermediate-term trend of 2.8% over the 2015 to 2019 period. The resumption of stronger growth is expected to reduce the unemployment rate as well to below 6% by 2018. The expected economic and jobs strength has positive implications for real estate occupancies, rent growth, and operations that can help offset, at least partially, any adverse price impacts of rising cap rates. Thus, the feared environment does not have to translate into catastrophic real estate performance.

Source: NCREIF, as of 4th Quarter 2012; TIAA-CREF

Exit assumptions matter

Common underwriting practices should also mitigate investor worries. Transaction professionals often use a rule of thumb in determining terminal cap rates, where exit cap rates are assumed to be 50 to 100 basis points higher than going-in cap rates over the holding period. This practice typically reflects the aging (finite life) of the property. As a result, cap rate increases are typically accounted for in return expectations, thus, eliminating some of the potential surprise associated with them.

The current cap rate spread is over 500 basis points; the 20-year historical average is slightly more than 300 basis points. That extra spread can absorb an increase in 10-year Treasury yields and/or a further reduction in cap rates before property values are affected. The extra spread can be viewed as a protective buffer from the expected rise in interest rates.

Economic growth matters

If this buffer is ignored and changes in Treasury yields are simply added to current cap rates, the results are scary. This simplistic method isolates the relationship between cap rates and property values, but fails to account for other factors that have the potential to offset value declines.

Cap rates rising: Fear and loathing in real estate

Simple scenarios
Perhaps the simplest way to isolate the impact of rising cap rates on real estate performance is to examine some scenarios using a simple internal rate of return (IRR) model. In our examples, we analyze ten holding periods, ranging from one to ten years, each using the same assumptions, but with various exit cap rates. By varying the exit cap rates, we can isolate the effects of rising cap rates over the different holding periods. The property purchase price, or initial value, is assumed to be $100. The going-in cap rate is assumed to equal 6.4% which is the average for 2012 NPI transactions. For simplicity, the model assumes that annual net operating income (NOI) growth equals 2.4%, the consensus inflation expectation from the Blue Chip Economic Indicators over a 10-year horizon. Research indicates that NOI growth has historically been able to keep up with inflation, but only with considerable capital expenditures.4 A capital expenditure to NOI ratio of 33% is used, taken from historical NPI data. Consensus expectations show that the 10-year Treasury yield will reach 3.4% in 2015 and average nearly 5.0% during the latter half of the ten year horizon. With the current 10-year yield at roughly 1.8%, this amounts to increases of 160 to 320 basis points. We assume that the current extra 200 basis point cap rate spread will absorb some of the increase and test potential cap rate increases of 0 (the base case), 50, 100, and 150 basis points.

Not surprising, all else equal, larger exit cap rate increases above the base case result in poorer overall investment performance. But, the deterioration is not uniform across time. The exhibit highlights that the timing of cap rate changes matters a lot. In the near term, cap rate increases have a dramatic impact on property performance, but as time passes, each of the scenarios IRRs approaches the base case. This occurs because of the 2.4% per year growth in NOI and the compounding associated with it which act as protection against adverse movements in cap rates. As long as NOI is growing, time will mitigate the negative impact of a rising cap rate environment.

Magic of compounding
The importance of compounding annual NOI growth can be further highlighted by examining its impact on end-of-holdingperiod values. In Exhibit 5, we show some scenarios for different NOI growth rates using the +100 basis point exit cap rate scenario.

Exhibit 5
Initial and end of period values using different NOI growth assumptions
$130 120 110 100

W Initial value W 1% growth W 2.4% growth W 4% growth

Time heals all wounds?

Results are shown in the exhibit below where the base case IRR of approximately 6.7% is subtracted from each of the scenarios across all holding periods.5 The purple line at 0% represents the base case IRR subtracted from itself.

90 80 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr Holding period 7 Yr 8 Yr 9 Yr 10 Yr

Exhibit 4
IRR differentials for 4 exit cap rate scenarios
5% 0 -5 -10 -15 -20 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr Holding period 7 Yr 8 Yr 9 Yr 10 Yr

Source: TIAA-CREF; Authors calculations This is a hypothetical illustration, based upon the assumptions described above. These results shown are for illustrative purposes only and do not reflect actual (product) performance. Changes in the assumptions will result in changes to the results shown.

W +150 bps W +100 bps W +50 bps W +0 bps

Source: TIAA-CREF; Authors calculations This is a hypothetical illustration, based upon the assumptions described above. These results shown are for illustrative purposes only and do not reflect actual (product) performance. Changes in the assumptions will result in changes to the results shown.

The results show the powerful impact of compounding annual NOI growth on property values. With NOI growth equal to consensus inflation expectations (2.4%), end of period property value (the green line) is anticipated to exceed initial value (the purple line) in Year 6. Greater NOI growth (4%) accelerates the breakeven point to Year 4 (where the blue line exceeds the purple line). More modest levels of income growth (1%) prolong the pain; the breakeven is not reached after 10 years (the black line does not cross the purple line), in fact, it is not reached until Year 14 which is not shown in the exhibit. Stronger than average NOI growth is a reasonable assumption here because the higher Treasury yields that we are expecting will only occur if economic growth strengthens. NOI will also benefit from the generally limited construction underway.
3

Cap rates rising: Fear and loathing in real estate

So, investors can do better by preferring properties and/or markets that exhibit solid NOI growth. This clearly has relevance for investment and market selection strategies. Evidence suggests that higher NOI growth tends to occur with higher probability in high-barrier-to-entry (lower cap rate) markets.6 Thus, higher-yield, bond-like (higher cap rate, limited NOI growth) property investments may not be as safe as sometimes perceived, particularly when low NOI growth rates and rising cap rates are a concern. This is an interesting implication given the current debate surrounding the desirability of low versus high cap rate investment in todays real estate environment.

Bottom line: keep calm and carry on

Fears that the eventual rise in interest rates will result in higher cap rates and declining property values are only justified if everything else is assumed to be unchanged. While this assumption might seem reasonable, it oversimplifies the more complex nature of reality and ignores factors that have the potential to offset value declines. As a result, investor fears are likely exaggerated.

In the paragraphs above, we explain that, first, cap rate increases are typically accounted for in return expectations through common underwriting practices and current cap rate spreads are above average. So, investors are prepared for some upward movement in cap rates. Therefore, they should not fear the cap rate increases that they expect, only the ones that they do not expect. Second, real estate performance is less sensitive to cap rate changes as the investment horizon lengthens. But, if cap rates rise in line with interest rates, they can have a dramatic impact on property performance in the near term. Thus, the timing of cap rate changes matters and time has the potential to heal most, but not all, wounds from rising interest rates. Third, compounding annual NOI growth has a powerful impact on property values; the stronger the growth, the greater the protection against adverse movements in cap rates. This last point has important implications for property and market selection, and suggests a strong preference for investments with solid NOI growth, further validating our target market selection process.7 It also suggests that higher-yielding, lower-growth investments may not be as alluring as some believe.

The changes in quarterly Treasury yields lagged one, two, three, four, and five quarters were used in separate OLS regressions to explain changes in cap rates. None of the equations produced significant t-statistics for the change in Treasury yields. 2 As evidenced by our own cap rate model, forecasting cap rates is a complex process that incorporates a variety of variables. Furthermore, it is difficult to forecast beyond a short time horizon with consistent accuracy. See Martha S. Peyton, Capital Markets Impact on Commercial Real Estate Cap Rates: A Practitioners View, Journal of Portfolio Management, Special Real Estate Issue 2009. 3 Note that using the full data sample from 4Q82 to 4Q12 results in a lower long-term average cap rate spread because 10-year Treasury yields exceeded transaction cap rates through much of the 1980s, resulting in negative cap rate spreads. The full-sample average equals 225 basis points. 4 See Mike Kirby and Peter Rothemund, Sector Allocation for the Long Run, Sector AllocationSpecial Report, Green Street Advisors, December 4, 2011. 5 See Joseph L. Pagliari, Jr. & James R. Webb, Past and Future Sources of Commercial Real Estate Returns, The Journal of Real Estate Research, Fall 1992. 6 See Mike Kirby and Peter Rothemund, REITs for the Long Run, Heard on the Beach, Green Street Advisors, January 31, 2013, and Mike Kirby and Peter Rothemund, Do Quality Snobs have a Point?, Heard on the Beach, Green Street Advisors, November 30, 2010. 7 See Martha Peyton and Edward F. Pierzak, Winning Markets: Persistence in Target Market Portfolio Performance, TIAA-CREF Global Real Estate, February 2013. The material is for informational purposes only and should not be regarded as a recommendation or an offer to buy or sell any product or service to which this information may relate. Certain products and services may not be available to all entities or persons. Past performance does not guarantee future results. Investments in real estate are subject to various risks, including fluctuations in property values, higher expenses or lower income than expected, and potential environmental problems and liability. TIAA-CREF Asset Management provides investment advice and portfolio management services to the TIAA-CREF group of companies through the following entities: Teachers Advisors, Inc., TIAA-CREF Investment Management, LLC, and Teachers Insurance and Annuity Association (TIAA). Teachers Advisors, Inc., is a registered investment adviser and wholly owned subsidiary of Teachers Insurance and Annuity Association (TIAA). TIAA, TIAA-CREF, Teachers Insurance and Annuity Association, TIAA-CREF Asset Management and FINANCIAL SERVICES FOR THE GREATER GOOD are registered trademarks of Teachers Insurance and Annuity Association. 2013 Teachers Insurance and Annuity Association-College Retirement Equities Fund (TIAA-CREF), 730 Third Avenue, New York, NY 10017
1

C10181

184925_321301 (04/13)