One relationship says it all 2

Real estate and the Federal Reserve
May 19, 2016

No meaningful relationship between NAREIT index return and interest rates fluctuations

We introduced Ms. Nunez, a real estate mogul, in the last post. She had wanted to sell sixty percent of her real estate portfolio because she expected interest rates to change. She felt her real estate portfolio market value would decline and it would be challenging to service the debt.

As it turned out, rates did not move much. She canceled the intended portfolio bulk sale, and decided to purchase five two-year options to purchase five properties, potentially adding 200,000 square feet of office space to her real estate portfolio.

Her story demonstrates that interest rates play a major role in the decision whether or not to purchase or sell real estate. And we argued that it is a fallacy.

The relationship between interest rate movement and property value movement appears to be mutually exclusive. But it is not. We are incorrect to assume that a movement in one variable (say, interest rates going from 2% to 3%) will affect the other variable (property values will decrease by 15 percent for example).  

Pen&Paper defines a weak relationship when a predicted outcome has less than 50 percent chance to occur. If you are confident that sports team ABC will win (or lose) and in over five out of the ten past games, you were incorrect, then we would say your ability to predict a sporting event outcome is weak.

The five-year Treasury represents the interest rate variable. We use the five-year treasury as a benchmark for interest rates because:

1.     It represents a typical investment time horizon.

2.     Lenders often use the rate to price a fixed-rate commercial real estate loan.

The NAREIT index represents the commercial real estate property value. This index represents a comprehensive family of REIT performance indexes that spans the commercial real estate space across the U.S. economy. This index provides investors with exposure to all investment and property sectors. 

Relationship between interest rates and property values

Looking at a 40-year historical record, you can see that the relationship between the movement of interest rates and property values is weak. We looked at the data using three scenarios:

1.     3-Year window: between 1972 and 2012, there were fourteen three-year periods. In six out of fourteen periods, we see the inverse relationship between interest rate movement and property values.

Three year relationship between interest rates and NAREIT index

2.     5-Year window: between 1972 and 2012, there were eight five-year periods. In only three years of the eight-year period, we see a “Ms. Nunez” relationship. That is, expecting property values to decline with an increase in interest rates. However, in most of the periods, the interest rates went up, and property values followed. Or, interest rates dropped significantly, and property values did not skip a beat.

Five year relationship between NAREIT index and interest rates

In short, by observing the 40-year track record of property values and interest rates, we find a weak relationship between the two variables. And if the two variables are not related, i.e. mutually exclusive, then one variable cannot change the other’s movement. 

With the assumption the trend will continue, it is better to ignore interest rate movements as property value predictions.