Whenever real estate comes up in investment circles, everyone asks: “But what about interest rates?” Today we will explore the real relationship between real estate and interest rates—one that every savvy investor should understand. And you might be surprised by what you learn.
The Mechanics of Real Estate
In commercial real estate (CRE), it is standard for parties to use lease agreements that detail the rent due over the lease term. Many lease agreements require the renter – not the property owner – to cover insurance, taxes, and maintenance. If you've ever rented an apartment or storage unit, you get the gist.
Now, imagine you're the landlord: when interest rates climb, at first, nothing seems to change. Most CRE mortgages are fixed rate over a 5-20-year term, so those payments remain unchanged. And the rent checks keep rolling in. So, what’s the concern?
There are three ways higher interest rates can be problematic. First, the CRE mortgage eventually matures. If that happens when rates are still higher, the extra interest expense with the new loan is an immediate hit to the bottom line. For context, the increase in rates since 2020 may reduce profitability by 50% (or more for some properties). The terms of most lease agreements make the ability to pass that extra expense on to the renter impossible.
Second, the identical problem applies to prospective buyers of CRE. Sure, the existing landlord might be generating an 8-10% return in part because they secured debt financing when rates were much lower. But that doesn’t matter to a buyer that has to secure a mortgage in the current interest rate environment. That’s why changes in interest rates have a big impact on property values.
Last, higher interest rates make other investment opportunities more appealing. A property yielding 6% annually appeared attractive compared to a Certificate of Deposit (CD) yielding 2%. That was the norm for much of the past decade. However, interest expense has increased at a rate much higher than average rent in the past few years. If an investor is looking at a 5% annual return on a piece of real estate and a 5% return on an FDIC-insured CD, the decision to invest in real estate is not clear cut.
So, do higher interest rates always mean lower real estate values? Not exactly, and in some cases, it may be the opposite.
The Data vs. the Theory
CoStar—a leading real estate data firm—recently reported that U.S. single-family home prices achieved their ninth consecutive all-time high.
Despite U.S. mortgage rates near a 10-year peak, home prices keep breaking records. What’s driving this?
Real Estate Investment Trusts (REITs) are publicly traded legal entities that focus on either owning physical properties (equity REITs) or investing in real estate mortgages (mortgage REITs). About 90% of REITs, by market capitalization, are equity REITs, meaning diversified REIT indexes mainly reflect companies that own properties
Since REITs encompass nearly all types of real estate—from movie theaters and cell towers to office buildings—they provide a broad representation of the overall real estate sector. For analysts, REITs are valuable because they must publicly disclose all key financial and operational data in regular SEC filings—something other real estate owners generally don’t do.
Consider a 25-year period chosen by Standard & Poor’s: REITs outperformed all other major asset classes, despite facing three periods of significant inflation—each accompanied by rising interest rates just like we are experiencing today. If higher rates were indeed a death knell for real estate, REITs wouldn’t have delivered such a strong performance.
REITs historically outperform the S&P 500 during periods of moderate and high inflation (though they slightly underperform during low inflation).
In the chart above, notice the substantial “income returns” column in light blue for REITs during moderate and high inflation periods. Real estate landlords have historically passed on inflation costs with each new lease. For self-storage or apartments, there’s a potential to increase rents monthly. This can lead to outperformance. However, for office and industrial spaces, with leases extending up to a decade, it might take years for the property owner to effectively raise rents. These long-term leases usually have 2-3% annual increases, which are fine most of the time. But when inflation really increases, landlords can’t keep up. Therefore, choosing the appropriate type of real estate, along with the associated leases, is crucial.
There is another major factor influencing these numbers. Inflation increases the replacement cost of any building, which is another advantage as labor, land, and construction materials become more expensive. Imagine the difference between building a home today versus the year 1990.
Over the past 50 years, real estate has handled inflation better than other asset classes, mostly because of higher rents. This, along with other factors, has made REITs the top-performing major asset class during recent inflationary periods. Note that the current period is not included in this analysis.
In the chart above, the right column compares the total return of REITs to the S&P 500. A positive number indicates that REITs outperform the index, and vice versa. Of the last six inflationary cycles since 1976, REITs outperformed in three (the late 1970s, early 1980s, and mid-2000s), tied in one (late 1990s), and underperformed in two (the mid-1980s and mid-1990s).
What's especially striking is how significantly REITs have outperformed during certain periods. In both the late 1970s and mid-2000s, REITs significantly outpaced stocks by a margin of 91.4% and 70.6%, respectively.
During the late 1970s, inflation reached its highest level in modern history. The Consumer Price Index (CPI), which serves as the benchmark for U.S. inflation, peaked at a staggering 14% in 1980. Interest rates, in response, climbed to nearly 20%. The primary drivers behind this surge were rising food and energy costs, coupled with the failure of wage-price controls implemented by the Nixon administration.
This period is often described as "stagflation," a term that denotes high inflation combined with sluggish economic growth. High inflation proved beneficial for real estate, while the slower economic growth weighed heavily on stocks, leading to real estate's relative outperformance.
Fast forward to the mid-2000s, real estate once again outperformed stocks, this time because of a combination of factors. Government subsidies for single-family and multifamily residential loans, what many now see as a prolonged period of artificially low interest rates, and the expansion and securitization of the mortgage market all contributed to a real estate boom. Valuations always matter, and that applies to real estate as much as any other sector. The euphoria was short-lived, as those who invested in real estate during the 2008-2009 financial crisis painfully remember. While real estate took a hit, it wasn’t alone—stocks and nearly every other asset class also experienced sharp declines.
Key Takeaways
Real estate doesn’t have the straightforward relationship with interest rates that many investors assume. For the last 50 years, inflation has been a net benefit to real estate investors. It's important to remember that since this is calculated over the entire inflationary period, short term performance within that time is often volatile. And nobody can say with certainty how long the current inflationary period will persist. In reality, that depends on decisions by policy makers that have yet to be made.
When inflation rises and the economy is robust, both property values and rents generally rise, That applies even if the Federal Reserve hikes interest rates to cool things down. In a booming economy with low inflation, real estate tends to do reasonably well but may not outperform indexes like the S&P 500. For example, a technology stock may increase in value many times over in a single year. That’s not realistic for real estate.
Much of this analysis uses historical data, There is no guarantee past trends will repeat, and new factors may change how real estate and interest rates interact. The impact of the pandemic and related government policy on office properties are a good reminder of that.
Currently, inflation is still near its 40-year high. Contributing factors include record federal budget deficits, escalating national debt, lingering effects of global COVID-19 spending, and a tight labor market in many developed countries like the U.S. These issues don’t have simple or quick solutions.
If we look at the past 70 years, income-producing real estate hasn’t been vulnerable to rising interest rates as many believe. In fact, it has outperformed nearly all other asset classes during the inflationary periods that coincide with higher interest rates. Different property types and lease structures react differently in inflation and changes in interest rates. That’s why diversification across many segments of the real estate market can be prudent.
So, of course, even though a recession is always a possibility, its nature remains uncertain until it happens. By holding a diverse mix of investments with distinct economic drivers, which, in fact, does include real estate, a portfolio has a much better chance of weathering
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