This is a guest blog from Shaun Riley at Faris Lee Investments in anticipation of ICSC RECon 15. Visit them at Booth C150M.
We’ve all heard the warning for several years now…interest rates will increase and when they do, be ready for a bumpy ride. While the eventual upward tick in interest rates may cause some uncertainty in the market, there are other fundamentals in place which should definitely soften the negative impact of rate increases.
For starters, the U.S. commercial real estate market is regarded as the strongest in the world. The U.S. retail investment sector is continuing to benefit from an unprecedented influx of foreign capital. The attention has been broad-based from Sovereign Wealth Funds to high net worth investors. The common denominator amongst these investors is preservation of capital via quality properties located in a more stable economic environment.
Currently, investor demand exceeds market supply for most retail property investment categories. Low interest rates and the search for yield have helped drive this demand, however, I would argue that fundamental factors such as decreasing vacancies, improving lease rates, lower unemployment, and lack of new retail development is just as responsible. Additionally, retail investment properties are a more active part of investors’ portfolios compared to past environments of interest rate increases and investor pools are much deeper now than they were just 10 years ago. These factors will play a major role in limiting the negative effect on rising interest rates for the retail investment market.
In previous real estate downturns, Class B and C properties have been hit harder than Class A properties. Looking forward, investors should realize cap rate spreads between A, B, and C properties are currently as narrow as the market has ever seen. Rather than focusing primarily on yield as many investors have done in this current market, the investor should be evaluating opportunities from a more fundamental perspective. Evaluating property-level metrics such as determining if pricing power resides with the landlord or tenant and if the property has inherent upside, have always been keys to successful investing.
Historically, movements in cap rates and interest rates have a direct relationship with cap rates usually rising following interest rate increase. Strong real estate fundamentals, a more broadly held investment market than in past rising interest rate environments, and a refocusing on proven property-level analytics when making investment decisions will help all of us navigate more effectively through the next interest rate increase.