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Thursday, 17 January 2019

Do Leases Insulate Investor Returns from Rising Interest Rates?

Leases with inflation clauses prevent the erosion of cash flow, and ultimately the valuation, of commercial assets. These clauses have helped blunt the impact of rising interest rates, but to varying degrees across time.

By Ryan Severino

While the relationship between interest rates and capitalization rates is complex and relatively well researched, far less has been researched about the relationship between interest rates and total returns.

In this brief examination, we look at the historical relationship between interest rates and total returns. We do not seek to examine the question of causation - we are simply looking to understand whether total returns for commercial real estate provide some insulation against rising interest rates.

In a rising interest rate environment, asset values generally fall as discount rates increase, resulting in a lowering of the net present value and a declining appreciation return. To offset that downward value pressure, property cash flows would have to increase, upping the income return. Of course, as valuations decline, ceteris paribus, income returns will increase, which would theoretically offset the decline in appreciation return.

Interest rates tend to increase during periods of stronger economic growth. At the short end of the curve, central banks like the Federal Reserve increase interest rates to prevent the economy...

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