If you have real estate assets in your portfolio, rising interest rates should be on your radar. In general, rising rates may mean a lower return for investors using borrowed capital, explains Stephen Thomas, Real Estate Advisory Specialist for Wells Fargo Private Bank.
"Currently, rising rates may have a greater impact on construction than on purchasing existing assets," Thomas says. "The supply of higher-end property has increased dramatically, and if the rates rise, this trend may slow as developers are forced to do more with less."
At the same time, an increase in rates can signify confidence in an improving economy to the Fed, Thomas says. This confidence is likely positive for real estate investors, as increased employment and wages can lead to reduced vacancy and increased rental rates. What does all this mean for the real estate assets in your portfolio? Here, Thomas and Ryan McDowell, Real Estate Advisory Specialist for Wells Fargo Private Bank, outline the key considerations to keep in mind.
Understand the impact
Real estate values are near all-time highs. But McDowell explains that if real estate values get ahead of economic drivers, that can make ownership less obtainable or attractive for commercial tenants and residential users alike. Those concerns can be kept at bay by continued extremely low unemployment, less real estate development, and continued positive GDP growth.
McDowell points out that October's Wells Fargo U.S. Interest Rate Forecast calls for an increase in the federal funds target rate to 2.5 percent by the end of 2019. "This is still well below the historical average of 4.88 percent since 1954 and is not expected to have a tremendous impact on real estate values in the near term," he says. But he also adds, "We are mindful that asset prices are unlikely to remain high indefinitely."
Both short- and long-term investments deserve a close look. "An asset that isn't viable with a 50-basis-point rate increase may not be the right fit," explains Thomas. "Even if an investor isn't using leverage, a 50- to 100-basis-point rate increase could cause a value decrease that may wipe out any near-term appreciation and completely change the dynamics of an investment."
Take additional preparation steps
Investors can prepare by first reviewing the risk exposure of their current real estate portfolio, says McDowell. Questions to ask include:
- Are the assets in your real estate portfolio consistent with your current investment strategy? (For example: an income strategy but holding non–income producing land.)
- What is your exit strategy for each real estate asset? How would your exit plan be affected by a real estate market downturn?
- How would the current assets in your portfolio perform if a market downturn occurs, and are you satisfied with that outcome?
McDowell reminds investors that Wells Fargo's Real Estate Asset Management group can help clients analyze and answer these questions and more, and provide strategies and execution that are designed to help improve investment outcomes.
Remember: Location, location, location (and more)
Location is always going to be a primary consideration for real estate investments, Thomas says. He suggests that investors look beyond traditional gateway cities to second-tier cities experiencing population increases. This could mean better returns. Strength of tenants, age of property, quality of construction, and long-term improvements are also key factors in making a sound investment in real estate and increasing future net operating income.