Capital Remains Cheap Despite Looming Fed Hike

Capital Remains Cheap Despite Looming Fed Hike

People have been asking Spencer Levy where interest rates will be next year for the past seven years. Every year, he has said 100 basis points higher. “I have been wrong seven years in a row, just like every other economist on the planet,” says Levy, head of research, Americas, for real estate services firm CBRE.

As Levy can attest, predicting the trajectory of interest rates has been difficult in what remains a hyper-sensitive global economy. Yet many economists do expect that interest rates will begin creeping higher over the next year. The caveat is that interest rates are not likely to make a big move. “There is every indication that rates will stay very low for a very long time,” says Levy.

The Federal Reserve has not made any changes to the Federal Funds Rate since its 25-basis point hike last December. It is widely anticipated that the Fed will introduce another moderate increase in the fourth quarter, sometime after the U.S. presidential election. Although some had though the Fed would raise the bank lending rate this summer, those plans were tabled due to volatility following the Brexit vote, as well as weak GDP growth during the first half of the year. As of second quarter, GDP growth was hovering at about 1.2 percent.

The Fed controls the Federal Funds Rate, which directly impacts LIBOR—the benchmark used to price short-term floating-rate real estate loans. The Fed has a more tenuous hold on controlling the 10-year Treasury, which is used to price long-term fixed-rate loans. Even if the Fed raises short-term rates, the long-term rate could remain low as both domestic and foreign investors continue to pour money into 10-year Treasuries as a safe haven.

Global uncertainty and negative interest rates in countries such as Germany, Switzerland and Japan will continue to keep downward pressure on the 10-year Treasury. That investor demand has helped to push yields lower. The 10-year Treasury yield is down some 60 basis points since January to its current level of about 1.6 percent.

The bottom line is it is still a great time to be a borrower for both short and longer term loans. The bigger question for the commercial real estate industry is how will looming changes to interest rates and capital costs impact cap rates going forward.

Even if the Fed raises rates another 25 to 50 basis points, the investment sales market is not likely to have a significant reaction as rates are still incredibly low compared to historical levels. In addition, there are a number of factors that will keep downward pressure on cap rates even as interest rates rise, including compelling risk-adjusted returns for real estate and the strong demand from foreign investors for U.S. real estate, says Andrew Nelson, chief economist, USA, at real estate services firm Colliers International. “That being said, I don’t think cap rates can fall much further. In fact, cap rates have stabilized and even increased for some markets in the last year,” he says.

The commercial real estate market has already proved that it can handle higher rates. In 2013, the 10-year Treasury jumped from 2.0 to 3.0 percent from May through August 2013. Even though interest rates went up, cap rates did not follow and transaction volume remained strong, says Levy. “So I think real estate markets in the U.S. will be resilient to a rise in the 10-year rate, perhaps by as much as a 100 basis point rise,” he says.

The correlation between cap rates and interest rates is the “holy grail” of commercial real estate finance, adds Levy. There is a correlation, but there is no exact formula to precisely identify which markets may be more or less affected by an increase in interest rates and to what degree. Some markets will be more resilient than others due to a variety of factors, such as the cap rate compression that has already occurred, as well as property fundamentals and buyer demand.

CBRE published a research paper on Identifying Market Risk for Cap Rate Increase under Fed Tightening in September 2015 that modeled the impact of a rise in the 10-year Treasury from the second quarter of 2015 average of 2.16 percent to 4.05 percent by the fourth quarter of 2017. Under that scenario, the average increase in office cap rates in 11 markets studied was 122 basis points by the fourth quarter of 2018. Other key findings of the forecast included:

In every market, cap rate increases are smaller than the rise in yields on the 10-year Treasury.

Cap rate movement and potential value losses vary significantly by market.

Rising rents and NOI will help, but will not offset, cap rate increases.

Markets with the greatest cap rate compression are at most risk for cap rate increases and value drops.

In addition, secondary markets are also likely to feel a bigger impact on cap rates, because there is a much more powerful flow of equity capital into primary markets that will likely trump any negative impact from an interest rate increase, says Levy.

Some economists worry that the Fed has waited too long to raise rates. One concern is that the Fed has been using low interest rates to boost the economy for so long it won’t have any tools left to fight the next downturn or recession, says Nelson. A second concern is that the longer the U.S. has super low rates in place, it introduces distortions into the market and creates conditions for asset bubbles to occur, he adds.

Economists also make a good argument for why gradual, moderate increase could be welcome at this stage.

“The reality is that having very low interest rates for any sustained period of time really means that the world is pessimistic on future growth,” says Levy. “I actually hope that rates go up, and I hope that they go up by at least 100 basis points, because that would be an indicator that the world is more optimistic and expecting more growth.”

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