Impact of rising interest rates on cap rates
10-10-2006
Contrary to popular opinion, interest rates are only one of various factors that play a role in determining capitalization rates.
Capitalization rates – the rating of the physical property market – are determined over time by various factors in addition to interest rates, for example expected real-rental growth, and changes in investment demand. Capitalization rates and interest rates, therefore, are not highly correlated over time.
Interest rates have been on a steep secular decline since the 1990s − and, according to Rode & Associates CEO Erwin Rode, that trend remains intact, despite the recent up-ticks and those that are still expected. Hence Rode regards it as unlikely that capitalization rates will experience any notable upward pressure from professional investors such as listed funds.
Rode expects that, at most, the increasing interest-rate trend will stall the dive in capitalization rates and reduce the number of sales transactions.
It could be argued, says Rode, that non-residential sectional-title prices may be more affected by short-term interest-rate fluctuations, as such properties are more often bought by private investors or owner-occupiers than listed funds, and they tend to be more interest-rate sensitive because of their higher gearing requirements.
To consider this proposition, one would have to differentiate between owner-occupiers and private investors.
In making the buy-or-rent decision, potential owner-occupiers will consider expected movements in both interest rates (affecting the mortgage instalment) and market rentals (affecting the cost of the renting alternative).
Rode is of the opinion that in the current climate, it is probable that the expected movements in these variables will tend to cancel one another out.
In the case of the private investor, expected future movements in fundamentals (notably growth in market rentals and/or contractual escalations) and interest rates (gearing costs) will be considered.
Once again, these forces should cancel one another out in the current climate.
“When it comes to listed funds, however, they are not nearly as dependent on the cost of loan funds as private investors are, and they can take a longer-term view when they make buying decisions.”
Rode expects that the worst effect of rising interest rates will be seen in the private-investor market where considerable investment demand will be squeezed out of the market because of the higher required equity ratio.
He explains that this is the fundamental reason why institutions in SA dominated the property market during the era of high interest rates (from the 1970s to the 1990s).
