Rate hike not always bad for office capital values

With the impending interest rate hike later this year, there has been much concern over the adverse impact on office capital values.

Since the start of the Quantitative Easing (QE) by the US Federal Reserve in December 2008, the Urban Redevelopment Authority (URA) office property price index (PPI) has been up 43 per cent, thanks to the strong capital flows into Asia and the ultra-low interest rate environment which makes borrowing much cheaper.

According to real estate database provider Real Capital Analytics, capital inflows into Asia real estate rose from US$25.2 trillion in 2009 to US$54.9 trillion in 2014, growing at a compound annual growth rate of 16.9 per cent.

Given the increased demand from investors seeking higher returns, property markets in Asia have been on a multi-year boom, with prices in many gateway cities surpassing the previous peaks.

Now that QE has ended and an interest rate hike is looming, banks globally as well as in Singapore are set to raise their interest rates by the end of this year.

In fact, the fear of a possible impending rate hike has already cooled the investment sentiment somewhat, reducing total Asia real estate investment volume by 13 per cent year on year to US$20.6 trillion in the first five months of the year.

Conventional wisdom is that rising interest rates could affect office capital values in three ways.

Firstly, the fair market value of any real estate can be determined using the universally accepted discounted cash flow model. A higher interest rate increases the cost of capital, resulting in a lower net present value, ie a lower capital value.

Secondly, the capitalisation rates of the commercial property will have to be higher in a rising interest rate environment, as investors demand higher returns on office assets. If the rents remain constant, valuation will have to go down which leads to a fall in asset prices.

Lastly, on the demand front, an increase in the cost of debt also results in lower investment spending to avoid high interest payment. Lower investment demand reduces the attractiveness of the assets, causing prices to correct.

Values appreciate

Surprisingly, our research seems to suggest that the converse is true, which means that when interest rates rise, capital values actually appreciate more often than not. To simplify the explanation, only movements of the URA office PPI are illustrated here; but the same conclusion can be reached by using the URA residential PPI.

In our analysis, we investigate the movement of office PPI in relation to the three-month Sibor, or Singapore interbank offered rate, from Q3 1987 to Q1 2015.

There were altogether 44 quarters in which the three-month Sibor increased from the preceding quarter. Out of the 44 quarters, the office PPI decreased in only 15 quarters (34 per cent), but increased in all the other 29 quarters (66 per cent).

Even after accounting for the lagging effect (as the impact of rising interest rates on properties may not be felt immediately), the same conclusion still holds true.

Of all the quarters where the three-month Sibor rose, the office PPI still increased in 60 per cent of all the quarters, regardless of whether the impact was felt one quarter or two quarters later.

If this does not suffice, we also carried out the analysis of the PPI trends when there is a continuous rise in interest rates. Surprisingly, we still come to the same conclusion that office capital values tend to increase when interest rates rise.

From the historical movement of the three-month Sibor, five different periods of sustained increase in interest rates with no less than one percentage point over at least eight quarters are identified. They are from Q1 1988 to Q2 1990, Q1 1993 to Q4 1994, Q1 1996 to Q4 1997, Q1 1999 to Q4 2000, and Q1 2004 to Q2 2006.

With the only exception of the period from Q1 1996 to Q4 1997, which was the prelude to the Asian Financial Crisis, office prices continued to climb even during periods of sustained interest rate hikes.

So our analysis concludes that historically when interest rates rise, more often than not, office prices in Singapore also tend to increase. Therefore, it seems that the fear that the real estate market would crash as a result of the Fed rate hike may turn out to be unfounded.

So what is supporting the office prices when interest rates go up?

The main reason why interest rates need to be raised is no other than strong economic growth. The central banks tend to hike interest rates during periods of strong GDP growth so as to combat inflation and prevent the economy from overheating.

Positive impact

Strong growth in economic activities also have a positive impact on wealth creation, which props up investors’ confidence in real estate investment. It is the belief that prices will continue to shoot up that drives the demand for real estate. If the physical stock is not able to satisfy the increased demand and supply does not keep up the pace, a demand-supply imbalance will be created, leading to further price increases.

As a result, any dampening effect of rising interest rates seems rather negligible in the face of the positive effect arising from the strong economic growth.

So what does it mean for real estate investors?

A rate hike will only occur when the US economy is on a solid footing. A solid US economic recovery bodes well for the Singapore economy and its asset prices. However, the Fed has repeatedly shown its unwillingness to hike the interest rates at the slightest hint of weaknesses in the US economy. In addition, after Greece rejected the bailout terms in the landslide referendum on July 5, the Fed may be less inclined to raise interest rates should the financial crisis in the eurozone deepen.

What this means is either our office capital values will continue its upward trajectory should the rate hike be sustained, or falter because the US recovery is not on track, in which case, the persistently low interest rate environment looks set to continue for a while longer.



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