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How Rising Rates May Affect Real Estate Investors

Rebecca Lake

The Federal Reserve's decision to implement a 0.25 percent rate hike in December and again in March has sparked speculation on how bond yields may be affected, but the impact of rising rates is set to trickle over into other asset classes, including real estate.

With at least two additional rate hikes on the horizon for 2017 and more in store for 2018, real estate investors should be aware of what may lie ahead for their portfolios.

"If interest rates are on the rise against the backdrop of an improving economy, occupancy rates should be strong, which could bode well for certain sub-segments within the REIT space," says Noah Levine, senior vice president at UBS Financial Services in Park City, Utah. "With history as a guide, we see that REITs containing exposure to hotels and apartments have been least impacted by increasing interest rates."

[See: The 10 Best REIT ETFs on the Market.]

KC Sanjay, senior real estate economist at Dallas-based Axiometrics, says real estate investment trust investors should be aware that the underlying assets in a REIT may influence performance when rates increase.

"Apartment investors and REITs may see moderating total return because of moderating fundamentals to a sustainable level of growth, after seven years of substantial growth since the Great Recession ended -- not because of rising interest rates," Sanjay says.

Sanjay says that in the short-term, investments in industrial properties are expected to outperform other property types and alternative investments. He cautions that historically, mortgage REITs that tend to invest in securities are more sensitive and feel more of an impact from rate increases than equity REITs.

Jay Hatfield, portfolio manager of the InfraCap REIT preferred ETF (ticker: PFFR), warns the real danger for REIT investors lies in how quickly interest rates increase.

"REITs tend to decline when long-term interest rates rise rapidly," Hatfield says. "REITs have the highest correlation in the Standard & Poor 500's index to bond prices and interest rates, at approximately 45 percent, which is slightly higher than utilities and dramatically higher than telecoms at only 14 percent correlation."

Scott Crowe, chief investment strategist at CenterSquare Investment Management based outside Philadelphia, says investors must keep the broader picture in view.

"Some of the negative impact of rising rates will be offset by the fact that higher interest rates imply higher [economic] growth, which is positive for real estate cash flows," Crowe says. "A moderate increase in interest rates over the next couple of years shouldn't be a hindrance to real estate and REIT markets continuing to post positive returns."

Rising rates could, however, alter the landscape for investors who want to purchase investment properties directly.

Paul Durso, president of Durso Capital Management in Charlotte, North Carolina, says rising rates could make it more difficult for some investors to obtain financing.

"As rates increase, it makes borrowing money more expensive," Durso says.

Durso says investors should remember there's more to consider than just the interest rate. He recommends looking at the state, county and city taxes, the age of the property and any character flaws in the context of how those factors may influence its profitability.

Rising rates could be a boon for rental property owners if it pushes home affordability out of reach for prospective buyers, says Sean McCarthy, regional chief investment officer for Wells Fargo Private Bank in Scottsdale, Arizona.

[See: 9 Psychological Biases That Hurt Investors.]

"With the supply of homes below average supporting prices and mortgage rates approximately 20 percent above last year's lows, reduced affordability of ownership should keep rental occupancy high," McCarthy says. "Less elasticity of demand from renters along with inflation and wage growth leading to higher rents can help offset some of the stress from higher rates."

McCarthy says higher lending rates usually mean lower cash returns for investors who are employing leverage to purchase properties. As appreciation in property values may be curbed in a rising-rate environment, investors must determine whether the anticipated cash flow from owning a rental property will offset the financing and maintenance expense.

John LaForge, head of real asset strategy at Wells Fargo Investment Institute in Sarasota, Florida, says the same rules apply to commercial property investments.

LaForge says investors must take into account their ability to cover the interest costs of financing a property over the long run.

"Should an investor finance using a variable rate, they need to understand the associated risk," LaForge says. "If rates rise too fast, forcing an investor to roll into a higher rate down the road, they may find themselves upside down if rent increases cannot defer the extra interest cost."

Albert Choi, portfolio manager for the Private Client Reserve of U.S. Bank in San Diego, says commercial borrowers need to be mindful of how access to credit may shape up moving forward.

"We're clearly later in the economic cycle and lending conditions may begin to tighten," Choi says. "Spreads for cap rates are near historic fair value levels relative to U.S. interest rates. The opportunity in direct real estate has shifted up the value add chain, reflecting higher risks to investors."

One area of real estate investment that may see a more immediate impact is house flipping.

"If there's a cooling in the buyer pool because of people's buying power being reduced due to higher rates, there will be a higher amount of available product," says GieFaan Kim, associate broker at Triplemint and co-founder of New York-based Ampersand Properties.

Kim says that if supply and demand are thrown out of balance because of rising rates, the flipping market, which has made a resurgence since the recession, will likely lose some of its momentum.

Blake Christian, a tax partner at Holthouse, Carlin & Van Trigt in Long Beach, California, says rising rates may separate hardcore flippers from hobbyists.

[See: 12 Terms Every Investor Needs to Know.]

"Rising rates will undoubtedly thin out the number of flippers who are dabblers in the market," Christian says. "Most don't have the staying power to hold properties while a smaller number of qualifying buyers wait longer for loan approval."

Diversity will help investors maintain their portfolios when interest rates climb, Choi says.

"Depending upon the type of real estate owned, there are several ways to hedge against the impact of rising rates," Choi says. "REITs, for example, can be hedged using collars or structured notes. Hard assets can be hedged through the ownership of other asset classes, like stocks, bonds or commodities. A diversified portfolio will lower an investor's risk profile and perhaps even increase the opportunity for additional return."

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