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INVESTMENT
INSIGHTS
July 2013
PORTFOLI O DI SCUSSI ON
What will higher interest rates
mean for real estate?
INVESTMENT
INSIGHTS
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AUTHOR
Brian Nottage, PhD, CFA
Managing Director
Head of U.S. Research for Real Estate
Separate Accounts
Global Real Assets
brian.a.nottage@jpmchase.com
IN BRIEF
What will higher interest rates mean for real estate? Analysis from our Global Real
Assets (GRA) Research team indicates:
In the short term, the impact of rising rates on real estate capitalization (cap) rates is
likely to be minimal.
History has shown little correlation between interest rates and real estate cap
rates. This is understandable: Rising rates are generally consistent with an
improving economic environment in which vacancies can be filled, rents raised and
real estate cash flows enhanced, damping the negative impact of rising rates.
In the long term, current unlevered core real estate IRRs, at roughly 6.5% to 7.5%,
appear sustainable, provided:
10-year Treasury yields stabilize at 4.5% to 5.0% over the next five years
(consistent with our J.P. Morgan Asset Management Long-term Capital Market
Return Assumptions). This rate plus a 200 to 300 basis point spread (consistent
with historical core real estate premiums over normalized, risk-free Treasury rates)
suggests current real estate prices, in general, have a cushion against moderate
rate increases.
Real estate returns maintain a reasonable spread to competing assets (BBB bonds)
and mortgage rates (for 65% LTV commercial mortgages). Today, those spreads
are historically wide, leaving room for some tightening as rates rise.
Investors should remain cautious, however, as rising rates are likely to push levered
returns downward toward unlevered returns as debt becomes increasingly less
accretive; this has the potential to expose poor performing and overpriced assets.
In recent weeks, financial markets have grappled with the reality that the Federal
Reserve is moving to normalize monetary policyand in the process, definitively
bringing to an end the era of negative real interest rates. As a result, our clients are
increasingly asking the obvious question: What will the impact of higher inflation and
interest rates be on real estate pricing? Even for investors comfortable with todays
prices and implied relative returns, a legitimate concern is the extent to which cur-
rent attractive returns could be wiped out as the Fed normalizes monetary policy.
In this paper, we take a look at the potential short-term and long-term impacts of
higher interest rates on real estate total returns, cap rates and pricing. To be sure,
there is no single obvious answer to the question about the impact of rising rates;
the outcome depends on multiple interrelated assumptions. That said, if one accepts
our J.P. Morgan Asset Management Long-term Capital Market Return Assumptions,
1

which call for the 10-year Treasury to gradually settle at a 4.5% to 5.0% range over
the next five years, we believe that todays private real estate pricing, which assumes
unlevered total returns in the 6.5% to 7.5% range, is sustainable.
1
J.P. Morgan Asset Management Long-term Capital Market Return Assumptions-2013 estimates,
September 30, 2012.
2 | What will higher interest rates mean for real estate?
PORTFOLIO DISCUSSION: Title Copy Here
INVESTMENT
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What will higher interest rates mean for real estate?
The short-term impact
It is important to separate the impact of higher interest rates
into short-term and long-term effects. In the long term, the rel-
evant question is: Where do rates end up? In the shorter term,
the appropriate query is: How will we get to higher rates?
The road to higher rates can be steep, bumpy and without
warning signsas in the 1994 Federal Reserve tightening
cycleor less steep, orderly and well-marked, as was the path
of 10-year Treasury yields in the 2004 cycle (Exhibit 1). These
conditions can significantly influence the outcome for real
estate capitalization (cap) rates in the short term. Clearly, the
1994 cycle resulted in a suboptimal outcome from the point of
view of financial marketsone which the Fed is at pains to
avoid this time around.
2

The 1994 tightening caught markets off guard, leading to a
spike in long-term Treasury rates. The impact was felt in the
real estate market, but to a lesser degree than might be
expected. The 10-year Treasury rose from 5.6% to 7.5%
between 4Q1993 and 1Q1995, a 190 basis point (bps) increase.
Yet transaction cap rates over that period rose by only 40 bps,
from 9.0% to 9.4%.
In contrast, the 2004 tightening was well-telegraphed;
Treasury yields actually rose ahead of Fed action and were
well-behaved after the tightening began, rising a modest 4.6%
2
Will Fed tapering lead to a repeat of the 1994 sell-off?, J.P. Morgan,
May 15, 2013.
to 5.1% over the 2Q2004 to 2Q2006 cycle. Transaction cap
rates actually fell over that period, from 7.2% to 6.3%, as
investors began to underwrite stronger income gains (and
likely, lower risk premia) for real estate.
The weak link between changes in Treasury rates and changes
in cap rates seen, to varying degrees, in these two tightening
episodes, is not atypical. Viewed in the broader context of
almost 30 years of history (4Q1983 through 1Q2013) it is clear
that the correlation between these two rates is minimal
(Exhibit 2). The two tightening periods, as shown, are no
exception, even accounting for the slightly less favorable real
estate cap rate performance in 1994 through 1995. This lack of
a relationship in the short term makes sensewhen interest
rates rise, the economy is usually improving and the ability of
landlords to raise rents and fill vacancies is usually improving as
well, serving to increase cash flows and put upward pressure on
real estate prices (and downward pressure on cap rates).
3

We would expect the short-term response of cap rates to be
similarly minimal in the coming tightening cycle, particularly
given the expectation that the Federal Reserve telegraphs the
rise in rates better than they did in the 1994 episode.
3
Cap rates are one-year ahead income yields: cap rate
t
=NOI
t+1
/P
t
. If one
makes the simplifying assumption of constant income growth (a common
industry shorthand to a full DDR model), the cap rate
t
equals required
returns (RR
t
) minus expected property income growth (E(g
NOI
)): cap
rate
t
=RR
t
-E(g
NOI
). So even if required returns went up in complete lockstep
with interest rates (something we argue further on should not be expected),
an equal rise in income growth expectations would leave cap rates
unchanged.
3
4
5
6
7
8
9
-250 -200 -150 -100 -50 0 50 100 150 200 250
1994
2004
Y
i
e
l
d

(
%
)
Number of trading days before/after rst Fed rate hike in tightening cycle
Source: Moodys Analytics, U.S. Board of Governors of the Federal Reserve
System. 1994 series: February 5, 1993 through February 7, 1995. Time 0 is
February 4, 1994. 2004 series: June 30, 2003 through June 29, 2005. Time 0
is June 30, 2004.
Will the next rate rise be orderly?
EXHIBIT 1: 10-YEAR U.S. TREASURY YIELDS FOR TRADING DAYS
BEFORE/AFTER FIRST FED RATE HIKES IN 1994 AND 2004 CYCLES
4Q19931Q1995 2Q20042Q2006
-2.0
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
Year-over-year change in 10-year Treasury yield (%)
Y
e
a
r
-
o
v
e
r
-
y
e
a
r

c
h
a
n
g
e

i
n

p
r
o
p
e
r
t
y

y
i
e
l
d
s

(
%
)
-4 -3 -2 -1 0 1 2 3
Source: U.S. Federal Reserve, National Council of Real Estate Investment
Fiduciaries (NCREIF) Property Indices (NPI), Moodys Analytics, J.P. Morgan.
Quarterly data for the period from 4Q1983 through 1Q2013.
What happens to property yields as interest rates rise? Probably
little in the short term
EXHIBIT 2: YEAR-OVER-YEAR CHANGE IN 10-YR TREASURY YIELDS
(X AXIS) VS. NCREIF CAP RATES (Y AXIS) 4Q1983 TO 1Q2013
J.P. Morgan Asset Management | 3
INVESTMENT
INSIGHTS
The long-term impact
Over the long run, the key question is: Where do current real
estate returns sit relative to some long-term equilibrium esti-
mate of where those returns are likely to end up? One way to
address this question is through a broad capital markets
framework. As Exhibit 3 illustrates, within this framework,
core real estate, which has both bond-like and equity-like
characteristics, should be priced to provide total returns
somewhere between bonds and stocks. In addition, all risk
assets should be priced to offer a return premium to
normalized
4
risk-free Treasury rates.
What is a reasonable assumption for a normalized Treasury
rate? J.P. Morgans Long-Term Capital Market Return
Assumptions are a good starting point. Our strategists and
market experts estimate that the 10-year Treasury yield will
settle in at 4.5% to 5.0% over the next five years. The equity
risk premium is assumed to be about 400 basis points. The
core real estate premium, as one might expect, is assumed to
be lower, at 200 to 300 basis points, consistent with history.
Doing the rough math, equilibrium core direct real estate
total returns should be somewhere between 6.5% and 8.0%.
To look at current pricing in this context, Exhibit 4 shows pro
forma IRRs for core transactions underwritten over the past
decade within J.P. Morgans Global Real Assets (GRA) platform.
4
Normalization refers to the restoration of economic conditions, such
as interest rates, to more cycle-neutral levels, following a temporary
dislocation period.
The takeaway from this chart is that our underwriting IRRs
have settled at around 7.0%. Is that 7.0% return sustainable or
will it have to move higher when interest rates rise?
Exhibit 5 shows a simple analysis backing out the spread (in
basis points) between current underwriting IRRs, in the top
row, and equilibrium (or normalized) 10-year Treasury
rates, in the first column. In bold are the current range of IRRs
being underwritten today (roughly 6.5% to 7.5% unlevered)
and the range within which the our Long-Term Capital Market
Return Assumptions project 10-year Treasuries to stabilize over
the next five years (4.5% to 5.0%). This is essentially a next-
buyer exercise, designed to answer the question: If todays
Bonds Core direct real estate Stocks
Normalized
Treasury yield
Equity risk
premium
Source: J.P. Morgan. This chart is for illustrative purposes only.
Long term, the key question is: How much cushion is there in
current real estate prices?
EXHIBIT 3: REAL ESTATE ASSETS SHOULD PRICE TO PROVIDE A RETURN
PREMIUM BETWEEN BONDS AND STOCKS
3
4
5
6
7
8
9
10
11
12
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
P
e
r
c
e
n
t
Source: J.P. Morgan; data as of May 2013.
Are todays 7% IRRs sustainable, if rates rise?
EXHIBIT 4: MEDIAN IRR FOR CORE ASSETS AS UNDERWRITTEN BY
J.P. MORGAN ACQUISITIONS TEAM
6.00 6.50 7.00 7.50 8.00
3.00 300 350 400 450 500
3.50 250 300 350 400 450
4.00 200 250 300 350 400
4.50 150 200 250 300 350
5.00 100 150 200 250 300
5.50 50 100 150 200 250
6.00 0 50 100 150 200
Underwritten medium term IRR (%)

E
q
u
i
l
b
r
i
u
m

1
0
-
y
e
a
r

T
r
e
a
s
u
r
y

(
%
)
Source: J.P. Morgan.
Current core IRRs appear sustainable, if 10-year Treasury yields
settle below 5%
EXHIBIT 5: CORE IRR SPREADS TO EQUILIBRIUM TREASURY YIELDS
4 | What will higher interest rates mean for real estate?
PORTFOLIO DISCUSSION: Title Copy Here
INVESTMENT
INSIGHTS
What will higher interest rates mean for real estate?
average core buyer sold in five years, at which point Treasury
yields had risen to 4.5% to 5.0%, would the next buyer require a
higher return to be consistent with long-term return premia?
The answereven at a 7.0% IRRwould generally be no
given a 5.0% Treasury yield, as that would still provide a 200
basis point spread (though pricing would be tight, as this is
the low end of historical required spreads). However, if
Treasury rates end much higher than 5.0%, required returns
would have to move higher to achieve what has historically
been viewed as a sufficient return premium. If expected
income growth at that time does not rise commensurately, cap
rates will have to rise and prices fall. So part of determining
whether one is comfortable that todays return level is fair and
sustainable is staking a claim on where rates end up; a 5.0%
Treasury world is tight, but a 4.0% world would leave real
estate still looking very attractive on a relative return basis.
There is some built-in conservatism
in underwriting
In assessing the degree of cushion against rising rates given
current real estate values, it is important to understand the
assumptions behind todays IRR calculations. For example, in
anticipation of rising rates, todays IRRs, in general, already
incorporate an assumption of higher future cap rates. Exhibit 6
illustrates this point by clarifying the exit cap rate assumptions
behind discount rates (appraisal IRRs) on real estate held in
three GRA open-end funds covering the spectrum from core to
value-added. Discount rates range from roughly 7.4% to 8.0%
across strategies. In each case, exit cap rates are assumed to
be higher than initial yields by anywhere from 65 to 180 basis
points. If those higher exit cap rates were not assumed, unle-
vered total returns would be close to 8.8% and 8.3% for core
and core plus respectively and close to 10.4% for value add.
5

The cushion in todays values, therefore, may be even wider
than IRRs that incorporate the assumption of higher exit cap
rates suggest.
Competing spreads are not yet signaling
danger for real estate IRRs
A further necessary condition for a given level of underwriting
returns to be sustainable is a reasonable spread to competing
assets and to mortgage rates. Exhibit 7 shows the spread of
core underwritten IRRs to BBB bonds and to our proprietary
index of 65% loan-to-value (LTV) commercial mortgage rates.
In the last tightening cycle, these spreads approached histori-
cally narrow levels as early as 2006, portending a rise in core
IRRs. Today, both spreads, which speak directly to the ability
to obtain a mortgage and the relative return of similar risk
assets, are nearly as high as they have ever been.
Whats the takeaway?
Putting together two concepts: (1) unlevered returns relative
to current competing returns and (2) unlevered returns
relative to equilibrium Treasury rates, we can devise a way
to judge whether todays returns are sustainable or not.
A reasonable rule of thumb is that as long as there is a
decent core spread to bonds and debt, current return levels
5
Those IRRs typically assume 10-year holds and are built up as initial yield +
annual cash flow growthimpact of higher exit cap rates. The higher IRRs
are calculated by assuming exit yields=initial yields.
Source: J.P. Morgan; data as of March 2013.
Todays underwriting assumes sales in a higher rate environment
EXHIBIT 6: EXAMPLE OF DECOMPOSING GLOBAL REAL ASSET (GRA)
DISCOUNT RATES
Strategy
Gross Asset
Value
($bn)
Discount
rate (a)
(%)
Going-in
yield (b)
(%)
Exit cap
rate (c)
(%)
Difference
(c)(b)
(%)
Core 25.1 7.43 5.41 6.46 1.05
Core plus 2.3 7.56 6.03 6.68 0.65
Value add 3.1 7.93 5.10 6.91 1.81
-1.0
0.0
1.0
2.0
3.0
4.0
5.0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
P
e
r
c
e
n
t
BBB bonds
65% LTV mortgages
Source: J.P. Morgan, Moodys Analytics; data as of May 2013.
If core IRRs are too close to BBBs and mortgage rates, that is a
warning sign; today, spreads are historically wide
EXHIBIT 7: CORE IRR SPREAD TO DEBT YIELDS
J.P. Morgan Asset Management | 5
INVESTMENT
INSIGHTS
are very supportable with a 10-year Treasury that settles in
the low 4% range, tight but OK if we end up closer to 5%,
and pressured to move higher (and prices lower) at a level
much above 5%.
Caution is still called for
The forgoing thoughts are not an argument for investor
complacency, however. A 10-year Treasury that ended up at
4.5%-5.0% still makes a lot of 6.0% IRR underwritingswhich
are occurring in the marketlook very tight, one might say
priced to perfection. Even at 7.0% IRRs, there are headwinds.
In particular, the cost of debt would probably end up nearor
a bit abovetodays 5.0% to 5.5% income yields, making debt
only marginally accretive in many cases. Even when debt
remains accretive, the easy levered core strategy that today
routinely produces 9.0% to 10.0% levered returns would fade
away as levered returns converge toward unlevered returns.
In this context, it makes sense to think of todays anomalously
low interest rate environment as a (welcome) windfall to cur-
rent levered returns that will eventually moderate, exposing
both underperforming and overpriced assets along the way.
6 | What will higher interest rates mean for real estate?
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What will higher interest rates mean for real estate?
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