The impact of an interest rate hike on non-residential property
07-11-2005
To determine the impact of the pending rise in interest rates on capitalization rates, one needs to distinguish between two types of movement: structural and cyclical, says property economist Erwin Rode of Rode & Associates.
"Structural or secular movements refer to long-term trends. The significant decline in inflation over the last few years, and the concomitant decline in short-term interest rates, is deemed by the market to be of a lasting nature, as reflected in the sharp decline in long-bond yields. This structural decline in inflation and interest rates has resulted in the re-emergence of the private property investor for the first time in decades in South Africa, since positive financial gearing has become a reality again.”
Superimposed on this structural or long-term trend one will experience cyclical movements or swings. Put another way, sometimes interest rates will rise above and sometimes they will fall below their long-term trend, but they tend to come back to their trend line (unless the structural trend is changing, of course).
With core inflation gaining momentum, it is generally expected that the Reserve Bank may hike interest rates in the coming months. This hike is expected to be a cyclical or short-term upward movement in interest rates.
What effect will such a hike have on the property market? In contrast to listed property funds, private investors are very interest-rate sensitive, because when gearing is negative, they find it difficult to finance property purchases. Hence, in those markets where private investors are active, the sensitivity to an interest rate hike will be greater. The sensitivity of these investors was aptly demonstrated over the last few years during which declining interest rates resulted in a sharp decline in capitalization rates – especially in the smaller shopping-centre market.
One of the consequences of an increase will be that the precipitous drop in capitalization rates in this segment of the market, where private investors and syndicators are most active, will be arrested. In the case of syndications, promoters will also have to contend with higher income yields from competing fixed-interest instruments, so they will be forced on two accounts to re-evaluate their buying strategies.
Private investors and syndicators must therefore be very cautious at present not to pay too much for properties and overstretch themselves, because those investments might just turn around and bite them. The safety net of low interest rates that have rescued even those private investors who have overpaid for properties over the past two years may no longer be there to rescue them. The only safety net that will remain for them will be pending market-rental increases.
As noted, the institutional sector of the property market is far less sensitive to interest-rate increases as it is less dependent on loan finance.
