There has been much concern over the adverse impact that the impending United States interest rate hike later this year would have on office capital values here.

Since the start of quantitative easing (QE) by the US Federal Reserve in December 2008, the Urban Redevelopment Authority office property price index (PPI) has been up 43 per cent, thanks to strong capital flows into Asia and the ultra-low interest rate environment that 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 (S$34.9 trillion) in 2009 to US$54.9 trillion last year, 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 previous peaks.

Now that QE has ended and a Fed interest rate hike is looming, banks globally, including those in Singapore, are set to raise their rates by the end of this year. In fact, the fear of an imminent rise in borrowing costs has already cooled sentiment, reducing the total Asian 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 would affect office capital values in three ways.

First, 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, that is, a lower capital value.

Second, the capitalisation rates of commercial property will have to be higher in a rising interest rate environment, as investors demand higher returns on office assets. If 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 results in lower investment spending to avoid high interest payments. Lower investment demand reduces the attractiveness of the assets, causing prices to correct downwards.

Surprisingly, our research suggests that the converse is true, meaning that when interest rates rise, capital values appreciate more often than not.

In our analysis, we investigate the movement of office PPI in relation to the three-month Singapore interbank offered rate (SIBOR) from the third quarter of 1987 to the first quarter of this year. There were altogether 44 quarters in which the three-month SIBOR increased from the preceding quarter. As seen in Exhibit 1, out of the 44 quarters, 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. Where the three-month SIBOR rose, 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. Beyond this, we also carried out analysis of PPI trends when there is a continuous rise in interest rates. Surprisingly, we also came 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 1 per cent over at least eight quarters were identified.

They are: From the first quarter of 1988 to the second quarter of 1990; from the first quarter of 1993 to the fourth quarter of 1994; from the first quarter of 1996 to the fourth quarter of 1997; from the first quarter of 1999 to the fourth quarter of 2000; and from the first quarter of 2004 to the second quarter of 2006. With the exception of the period from the first quarter of 1996 to the fourth quarter of 1997, which were the months before the Asian financial crisis, office prices continued to climb even during periods of sustained interest rate hikes (Exhibit 2).

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

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

Central banks tend to hike interest rates during periods of strong gross domestic product growth, so as to combat inflation and prevent the economy from overheating. Strong growth in economic activity also has a positive impact on wealth creation, which props up confidence in real estate investment.

It is the belief that prices will continue to shoot up, which will drive demand for real estate. If the physical stock is not able to satisfy increased demand, and if supply does not keep pace, a market 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.

What does this mean for real estate investors? A rate hike will occur only when the US economy is on a solid footing. A robust US recovery bodes well for Singapore’s economy and, in turn, asset prices here. What this means is that office capital values in Singapore will either continue their upward trajectory in the face of higher rates, or falter because US recovery is not on track, in which case, the persistently low interest rate environment looks set to continue for a while longer.

ABOUT THE AUTHOR: Christine Li is director and head of Singapore research at property consultancy Cushman & Wakefield.