Long in the tooth, the current real estate cycle keeps going.
As we get deeper into the current real estate cycle, many investors are wondering if the sector is nearing its peak. Meanwhile, interest-rate expectations are weighing on the sector’s valuations. Higher interest rates would put pressure on growth rates and return expectations. Morningstar analysts think rates will remain historically low for the foreseeable future, but any uptick will have short-term implications on the sector.
To get a better read on the real estate cycle, how a rise in interest rates would affect real estate markets, and the long-term risks to the sector, I sat down with analyst Edward Mui, who covers the sector for Morningstar. Our interview took place on Oct. 31, and his answers have been edited for clarity and length.
Jerry Kerns: Let’s start by looking at the broad picture. Where are we in the real estate cycle? What’s your current outlook for the next 12 months?
Edward Mui covers real estate for Morningstar. His coverage list includes Welltower, Ventas, Simon Property Group, and Taubman Centers.
Mui: Like the broader market, the real estate sector has been in prolonged recovery since the recession eight years ago. It feels like we’re currently in the later innings of the real estate cycle; many REITs are experiencing historically high occupancies, there is still robust rental growth, and peak valuations are driven by not only the underlying demand for this real estate but also by the lower interest-rate environment that we’ve been in for quite some time. Numerous people here at Morningstar believe that we’ll remain in an historically low interest-rate environment, which should help support not only economic growth but real estate valuations. But with the potential of a U.S. Fed rate hike, there are a lot of questions right now in the market about where growth and valuations for real estate are going in the next 12 months.
Within the next year or so, I would still expect demand to be cyclically high. There’s not a catalyst that we see right now that would bring growth and demand screeching to a 2008–09 style halt, even though there are signs of deceleration from the cyclical or historical peaks of rental growth and occupancy.
Kerns: If rates go up, what would be the short-term effects to the sector?
Mui: Interest rates matter to REITs and real estate mainly because real estate is a very capital-intensive business. REITs and real estate investors need ample liquidity and access to capital markets to keep the markets going, not only in terms of purchasing buildings but also for developing new supply, signing new tenants, and even just for working capital purposes. The mental benchmark for real estate is the 10-year U.S. Treasury. As we know, the 10-year Treasury has been trading at historical lows for many years.