What Would Happen to Hotel Capitalization Rates if Interest Rates Increased by 150 Basis Points?

By Jack Corgel, Ph. D.

Executive Summary

  • During the current phase of the U.S. business cycle the 10-year U.S. Treasury rate is likely to increase by approximately 150 basis points, driven by upward pressure on real rates and assuming no unexpected inflation.
  • The general level of interest rates is the primary cause for changes in real estate capitalization rates.
  • Continuing Improvement in the U.S. economy should eventually result in positive change in interest rates, but also capitalization rate compression and NOI growth.
  • Investor sentiment and financial market liquidity also play a role in determining the real estate capitalization rate level and changes.
  • Given the absence of ‘lease friction’ hotel property capitalization rates should respond more quickly than those of other property types to economic news affecting interest rates.
  • Holding other important factor constant, my model indicates that a 150 basis point positive change in the 10-year U.S. Treasury rate will result in a 50 basis point increase in hotel capitalization rates.
  • At current levels of hotel capitalization rates – in a range of 6.5 to 8.5 percent – and an expected slow pace of interest rate changes my modelled outcome will not be terribly destructive to hotel property values.
  • Investors with hotels should have ample time to ponder disposition decisions without fear of losing gains while new investors will need to rely on the strong dividend flows currently being produced by hotels for a greater shares of total returns.

I.  Introduction

The Federal Reserve’s recent decision to leave the Federal Funds rate unchanged further extends speculation about the future shape of the U.S. yield curve given that global, and not just U.S., economic conditions and Federal Reserve policy modifications need to be considered along with their interactions. Despite the difficulty of pinpointing interest rates over the next 12 and 24 months, increases appear inevitable. Holding other factors constant, heftier capitalizations of incomes generated by capital assets, such as commercial real estate, exert downward pressure on values.
 
Typically, the other important determinants of capitalization rates do not remain constant as economic conditions change so they also will adjust to changing risk preferences and asset-specific income growth rates.1 Coincidental adjustments in both of these components (i.e., risk premium compression and income growth acceleration) could offset some or all the anticipated rise in risk-free rates.2 The net effect on real estate capitalization rates from an upward shift in the yield curve either could be neutral or additional compression, and not necessarily the anticipated increase.
 
Among the property types that comprise commercial real estate, hotels arguably represent the most intriguing laboratory for analyzing interest rate/capitalization rate relationships. Hotel real estate, absent of lease frictions, more resembles equity than bonds. Controlling for the varied provisions of leases by eliminating them from empirical analyses allows for the generation of pure, contemporaneous responses of capitalization rates to changes in interest rates. The absence of lease friction also minimizes delays in the recognition of property income growth as the economy expands. Finally because hotel real estate risk premiums historically exceed those of other property types, variations in hotel risk premiums may be more observable and measureable as risk preferences change.
 
In this article, I present estimates of how much the near-term interest rate (i.e., 10–year Treasuries) may rise during the foreseeable future given steady economic growth, gradual reduction in Federal Reserve accommodation, and current inflation expectations.3 Using these approximations, I statistically derive estimates of the interest rate elasticity of hotel capitalization rates. My predictions are that the general level of interest rates will eventually rise by 150 basis points from current levels to potentially a steady state, assuming no unexpected inflation, and that this rise would effectuate a 50 basis point hotel capitalization rate increase taking into consideration changes in risk premiums and NOI growth. The timing of the interest rate movement is, of course, difficult to peg but will likely be slow and gradual.
 
At current levels of hotel capitalization rates – in a range of 6.5 to 8.5 percent – and an expected slow pace of interest rate changes my modelled outcome will not be terribly destructive to hotel property values and investor sentiment. Existing hotel investors should have ample time ponder disposition decisions without fear of losing gains while new investors will need to rely on the strong dividend flows currently being produced by hotels for a greater shares of total returns.
 

II.  Interest Rates and Fed Policy Changes

Assuming that inflationary expectations remain low, the real rate of interest appears as the likely component of the risk-free rate to be immediately affected in a meaningful way from the combination of continued economic growth and less Federal Reserve accommodation. This thesis is conditional on there being room for upward movement in the real rate using the historical long-run average as a benchmark. Exhibit 1 presents the pattern of real interest rates measured as constant maturity yields on 10-year U.S. Treasury Inflation Protected Securities (TIPs) since these securities began trading in 2003. Prior to the Great Recession (i.e., 2003 to 2008) the average real rate was 2.01 percent. The recent real rate has hovered around .5 percent as measured from TIPs trading. If this series mean reverts and stabilizes at the pre-Great Recession mean, then without unexpected inflation the ceiling on near-term interest rate increases is approximately 150 basis points.

 
Analyses involving TIPs security yields have come under criticism because of TIPs market liquidity issues, specifically the need to account for the difficult-to-measure liquidity premium. As a robustness check on the TIPs analysis, I recreated the data prepared for a New York Times article by Krugman (2013) which shows the 54-year history of real rates computed as the 10-year U.S. Treasury rate minus the previous year core personal consumption expenditures (PCE). The recent history of this series (i.e., since 2003 to match when TIPs began trading) closely resembles the TIPs series in Exhibit 1 (r = .82). The long-run average covering the period 1960 to present indicates a real rate of almost exactly three percent. The average real rate using the Krugman series during the period 2003 through 2008 is 2.34 percent which favorably compares to the TIPs average rate for the same period of 2.01 percent. While the TIPs real rate has hovered around .5 percent since mid-2013, the real rate from the Krugman series temporarily moved up after mid-2013 to 1.35 percent. By mid-2015, the series settled back to .69 percent which is only a dozen or so basis point higher than the recent real rate from TIPs trading. Again assuming mean reversion to the 2003 through 2008 average, the ceiling estimate for the 10-year U.S. Treasury rate considering both methods appears to be about 150 basis points. Finally, CBRE Econometric Advisors’ base line forecast has the 10-year U.S. Treasury rate moving up between 134 and 189 basis points to a steady state which coincides with my estimate (Chervachidze, 2015).
 
Given these results, what would as much of a 150 basis point upward movement in real interest rates mean for hotel real estate capitalization rates? Before addressing this question the near-term prospects for inflation need to be considered for a full view of potential nominal interest rate movements.
 

III.  Current Inflation and Inflationary Expectations

Despite fears about accelerating inflation, the inflation rate has remained low and is expected to be in the range of one to two percent for the foreseeable future. Support for this conclusion comes from a number of sources including studies by Federal Reserve economists. The Federal Reserve has the stated goal of maintaining the inflation rate, as measured by the PCE price index, at the two percent level. Yet, the reported PCE has trended below two percent for the past several years.
 
Economists at the Federal Reserve Bank of Cleveland use a sophisticated method for measuring inflationary expectations that relies on inflation rate swaps (Haubrich, Pennacchi, and Richken, 2011).4 In a fairly recent analysis, their model indicates that investors expect a 1.7 percent inflation rate over the next decade. During Q2 2015 the difference between the 10-year constant maturity Treasury and TIPs index rates over the next decade place expected inflation also at approximately 1.7 percent.5 Regardless, the comparison of current and expected inflation rates does not support the conclusion that the U.S. will experience a meaningful near-term interest rate increase based on current expectations for rising inflation. And unexpected inflation as the name implies is …. not expected!
 

IV.  Interest Rate and Hotel Capitalization Rate Relationships

The commercial real estate capitalization rate literature has progressively deepened over the past decade. The findings from this research stream apply almost equally across all property types, including hotels. Most studies, past and recent, seek a better understanding of the determinants of property capitalization levels and changes therein, often while using the Gordon (1959) growth model as the foundation (see fn. 1).
 
A recent round of studies extends the variable set for explaining variation in reported capitalization rates beyond Gordon model variables to include investor sentiment (Clayton, Ling, and Naranjo, 2009) and credit availability (Chervachidze, Costello, and Wheaton, 2009 and Chervachidze, and Wheaton, 2013). Both variables demonstrate statistical significance for explaining variation in property capitalization rate levels. As in earlier studies, recent research confirms that the general level of interest rates is a dominate variable for explaining variation in commercial property capitalization rates.
 

IV.1 Statistical Analysis

 Exhibit 2 offers the opportunity to make a side-by-side visual comparison of the historical capitalization for hotels and 10-year U.S. Treasury rate series from Q1 1992 through Q1 2015. The exhibit indicates a common trend and a strong correlation (r=.75). The average spread between hotel capitalization rates and 10-year Treasuries equals 509 basis points. To better understand the statistical relationship between interest rates and hotel capitalization rates, the 10-year U.S. Treasury rate, rf, is regressed on the hotel capitalization rate, HR and an elasticity estimate is produced in post estimation.6 The results for the period Q1 1997 through Q1 2015 are as follows (t-statistics in parentheses):7


 
The 10-year U.S. Treasury rate alone explains nearly one-half of the variation in the hotel capitalization rate. The elasticity of .26 may be interpreted as a 1.0 percent change in the 10-year U.S. Treasury rate on average results in a .26 percent change in the hotel capitalization rate. Hotel capitalization rates, therefore, are fairly inelastic with respect to 10-year U.S. Treasury rates.8
 


If, for example, the 10-year U.S. Treasury rate were to increase from the 2.0 level to 3.5 percent level (i.e., the ceiling 150 basis point increase from the earlier discussion) representing a 75 percent change, then using the elasticity estimate from Equation (2) the hotel capitalization rate would increase by 19.50 percent (.75 x .26). If hotel properties were trading at 7.0 percent capitalization rates, the assumed change in the 10-year U.S. Treasury rate corresponds to an 8.37 percent hotel capitalization rate (7.0 x 1.1950). An approximate 3.5 percent ten-year Treasury rate and a hotel capitalization rate in the range of 8.25 to 8.50 have coincidentally occurred several times in the recent past, both before (e.g., Q1 2008) and after the Great Recession (e.g., Q1 2011).

IV.2 Expanded Statistical Analysis

An important extension for enhancing the estimation precision of the hotel capitalization rate and interest rate elasticity involves recasting the analysis on a multivariate platform to allow for any offsetting effects from fluctuations in risk premiums and NOI growth rates within the same model over time. This approach also offers the opportunity to control for possible influences of investor sentiment and credit availability. The conventional wisdom is that during economic expansions interest rates move upward, and coincidently, risk premiums compress and NOI growth increases. In the following regression the hotel capitalization rate continues as the dependent variable and the model includes the following explanatory variables (data sources in parentheses, time subscripts omitted):

Gordon Growth Model Variables

•    rf - The constant maturity 10-year U.S. Treasury rate (FRED).
•    rp – The spread between Moody’s Baa corporate bond yield index and the 10-year U.S. Treasury rate (FRED).
•    g – The expected NOI growth rate for the next five years (RERC).9 10

Controls

•    ic -Sentiment measured by an investment conditions rating specified by survey respondents using a one-through-ten scale (RERC).11
•    ca - Credit availability measured as the quarterly change in commercial bank real estate loans divided by GDP (FRED).
•    Yearly dummy variables for trend.
 
The equation estimated using these variables, shown as Equation (2), works quite well. All of the Gordon and control variables are correctly signed and statistically significant at the .10 level or better. The variables added to Equation (1) reduced the unexplained variation in hotel capitalization rates to four percent. Importantly for purposes of this article, the interest rate elasticity of hotel capitalization rates declines with the addition of Gordon and control variables from .26 to .09. The intuition for this change mainly comes from recognition of the simultaneous changes of risk premiums and income growth in the same equation as the risk-free rate.

 
  
Returning to the earlier example and revising the numbers accordingly hotel capitalization rates would increase by 6.75 percent (.75 x .09). Given that hotel properties are trading at 7.0 percent capitalization rates, the assumed 150 basis point change in the 10-year U.S. Treasury rate corresponds to a 7.44 percent hotel capitalization rate (7.0 x 1.0675). An approximate 3.5 percent ten-year Treasury rate and a hotel capitalization rate in the 7.25 to 7.50 range have not coincidentally occurred since 1997, therefore for this combination to arise NOI growth will need to be quite robust.

Summary

The real rate of interest is likely to begin mean reverting sometime during the next 24 months and when that happens the 10-year U.S. Treasury rate could increase by 150 basis points, assuming no unexpected inflation. I assume the pace of the upward movement will be slow thus giving investors the time needed to plan before making disposition, renovation, and acquisition decisions. Some increase in commercial real estate capitalization rates logically would ensue – the question posed in this article is how much?
 
The multivariate analysis performed here incorporates potential cross-current components of the Gordon model – spread compression and NOI growth – and includes controls for sentiment and credit availability found to be important determinants of commercial real estate capitalization rates from prior studies. The potential rise in hotel capitalization rates from a 150 basis point increase in the 10-year U.S. Treasury is about 50 basis points.
 
The main result directly applies to the upper-price segments of the hotel market spectrum – upscale, upper upscale and luxury – since RERC survey respondents primarily invest in institutional-grade hotels. Capitalization rate time series across property types, including lower-price hotels, tend to be highly correlated, and therefore by extension their interest rate sensitivities should not be markedly different. Chervachidze (2015) reports an estimated increase in office capitalization rates from Federal Reserve policy actions of 122 basis points by Q4 2018 which exceeds my estimate from a multivariate analysis.
_____________________________________
1 The standard expression following Gordon (1959) is R = (rf + rp) – g, where R is the capitalization rate, rf and rp are the risk-free rate and risk premium, respectively; and g is the constant growth rate in net income.
2 Yeatts (2013) argues that upward movements of NOIs will come as the result of lease renewals at higher rents.
3 A debate continues as to how much a Federal Reserve policy change directly effecting the short end of the yield curve will influence rates on the long end.
4 See http://www.clevelandfed.org.
5 These data are available through the Federal Reserve Bank of Saint Louis (FRED, 2015).
6 The hotel capitalization rate is a blend of Real Estate Research Corporation (RERC) survey data and Real Capital Analytics (RCA) transaction data.
7 Estimations use data from Q1 1997 instead of from Q1 1992 because certain variables in the multivariate analysis to follow begin in Q1 1997.
8 A statistical test was run to determine if the interest elasticity differs during periods of declining interest rates relative to rising rates. The results indicate only a slight difference, that is, the elasticity is .25 as interest rates rise versus .26 for the entire time series.
9 NOI growth estimated from rent and expense growth survey data following the method in Lee, Corgel, and Shin (2014).
10 Estimated with a two-quarter lag.
11 Estimated with a three-quarter lag.

References

Identifying Market Risk for Cap Rate Increase under Fed Tightening. CBRE Research, About Real Estate, U.S. Office Investment, September 2, 2015.
 
Journal of Portfolio Management, 2009, Special Real Estate Issue, 50-69.
 
Chervachidze, S, and W. Wheaton. What Determined the Great Cap Rate Compression of 2000-2007, and the Dramatic Reversal During the 2008-2009 Financial Crisis? Journal of Real Estate Finance and Economics, 2013, 46, 208-231.
 
Clayton, J., D. C. Ling, and A Naranjo. Commercial Real Estate Valuation: Fundamentals Versus Investor Sentiment. Journal of Real Estate Finance and Economics, 2009, 38:1, 5-37.
 
Lee, H. S., J. Corgel, and S. Shin, Estimating Net Operating Income Growth for Modeling U.S. Apartment Property Capitalization Rates, Journal of Real Estate Portfolio Management, 2014, 20:1, 67-78.
 
Federal Reserve Bank of Saint Louis, Federal Reserve Economic Data (FRED), Economic Research, 2015.
 
Gordon, M. J. Dividends, Earnings, and Stock Prices, Review of Economics and Statistics, 1959, 41:2, 99-105.
 
Haubrich J.G, G. Pennacchi, and P. Richken. Inflation Expectations, Real Rates, and Evidance from Inflation Swaps, Federal Reserve Bank of Cleveland, working paper, March, 2011.
 
Krugman, P., 54 Years of Real Interest Rates, New York Times, August 22, 2013. Real Estate Research Corporation (RERC), Real Estate Report, 2015, 44:1.
 
Yeatts, T., Interest Rate Growth Will ‘Substantially Cancel Out’ NOI Growth Over the Next 12 to 24 Months, Experts Say, SNL, October 15, 2013.
 
 

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Jack Corgel, Ph. D. Jamie Lane
Senior Advisor to PKF Hospitality Research | CBRE Hotels Senior Economist
Robert C. Baker Professor of Real Estate ​PKF Hospitality Research | CBRE Hotels
School of Hotel Administration, Cornell University
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