Was the Pause In Rate Hikes Simply Too Late?

A decision by the Federal Reserve in early August to hold the overnight fed funds rate at 5.25% brought a sigh of relief from most commercial real estate professionals, who welcomed the news as a sign that brisk volume in investment sales will continue uninterrupted.

“Most buyers and owners view this in a positive way,” says Eric Anton, senior managing director at New York-based Eastern Consolidated, a full-service real estate investment services firm. “It's helpful to the industry.”

Yet the Fed's pause was probably too late to avoid a recession for an economy that was already slowing, economists say. The flat yield curve is a primary cause of concern, and has grown more worrisome since the Fed's Aug. 8 announcement.

The 10-year Treasury yield closed at 4.93% on Aug. 8, the day the Fed kept the overnight lending rate at 5.25%. Normally, long-term rates are higher than short-term rates, but in this case the 10-year Treasury yield fell another 12 basis points to 4.81% by Aug. 22. If investors interpret the Fed's decision as an indication that inflation is in check, the long-term yield may drop further.

The 10-year Treasury note will indeed move closer to 4.5% in the coming weeks, making the inverted yield curve more pronounced, predicts James Smith, chief economist at Parsec Financial Management in Asheville, N.C. Historically, an inverted yield curve lasting a month or more has been a prelude to economic recession, Smith says. “Why should 2007 be any different if this happens?”

An inverted yield curve does strain the banking system, agrees economist Anthony Pierson, managing director of portfolio management at Cornerstone Real Estate Advisers. But Pierson isn't convinced the yield curve will remain inverted for long. At times, the low yield on long-term bonds can suggest that investors expect the economy to stumble, he explains. But in this case, the low rate more likely reflects a high demand for the security of bonds as investors avoid volatility in the stock market, adds Pierson.

Rather than emphasize the yield curve, Pierson advises commercial real estate investors to keep an eye on slowing employment growth (see accompanying chart). The 113,000 jobs created in July were below the 124,000 jobs added in June and well below the 145,000 economists had predicted — the fourth straight month that employment gains fell short of expectations.

“That's the thing that could hurt real estate investors the most,” Pierson says. “Right now demand is good for most property types, from both a capital perspective and a tenant perspective, but if employment slows down, that puts some of the demand at risk.”

With high energy costs, a cooling housing market and the effects of previous Fed rate hikes slowing the economy, commercial real estate developers will slow the pace of new development, says Dana Johnson, chief economist at Comerica Bank in Detroit. “The pricing of loans isn't going to be a problem,” however, he says. “Some lenders may become more cautious, but the pricing is going to be pretty attractive.”

Even in the event of a recession, economists say there isn't great cause for concern on the real estate front because developers have kept supply in check since the 2001 recession and technology bust. Economist Smith predicts the coming recession will be like its 2001 predecessor, swift and mild, but without the accompanying office glut that resulted from a correction in the technology job market.

“Commercial real estate markets will be very strong for the rest of 2006 and well into 2007, perhaps for the entire year,” Smith says. “They'll fall in 2008 and turn back up in 2009 and beyond.”

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