On December 16, the Federal Open Market Committee (FOMC) will meet to discuss, among other things, whether to raise the Federal Funds Rate, the base rate for all other interest rates in the US economy, for the first time since 2006. With recent positive economic data points such as the most recent jobs report, which show that the economy added 211,000 jobs in November, reaffirming the strength of the labor market, market watchers currently have the probability of a rate hike at 80%.
A mentor of mine once remarked that his go-to question when interviewing job candidates was, “What happens to asset prices when interest rates go up?” Generally speaking, the answer is, of course, “They go down.” Assuming they answer correctly, the follow-up question would simply be a request for the candidate to explain their answer. My answer to that question, put simply, is that as investors’ cost of capital increases, their purchasing power decreases.
Similarly, in the commercial real estate business, conventional wisdom is that rising interest rates put downward pressure on property values. With that being said, commercial real estate professionals would be wise to take a more nuanced and holistic analysis on the matter, as the correlation between interest rates and cap rates is not as strong as some might suspect.
According to data published by the St. Louis Fed and Green Street Advisors, the spread between cap rates and 10-year Treasury yields is greater than the historical average, which suggests that there is room for compression. From 1986 through Q2 2015, the average spread has been 286 basis points versus the current spread of 361 basis points. In Q2 2007, the spread was only 119 basis points. Even further, a reasonable argument can be made that commercial real estate values will not only not be negatively affected by a fed rate hike, but that they still have room run.
Thus far, the Federal Reserve has been reluctant to raise the Fed Funds Rate due to their lack of confidence that the US economy is strong enough to withstand a rate hike. A decision by the Fed to raise rates would be a very strong indicator of a positive economic outlook. With economic growth comes growth in jobs, consumer spending and capital investment, all of which put strong upward pressure on commercial real estate values.
In addition to strong market fundamentals, US real estate will continue to benefit from increasing investment from foreign capital. The strength of the US economy, attractive risk-adjusted returns and the liquidity markets, and an accommodating government regulatory environment relative to other global markets, have fueled capital flows to US real estate. Inbound foreign capital is expected to eclipse 2007 levels in 2015, with estimates ranging from $70 to $80 billion.
Finally, new supply will be kept in check by restrictive government regulations from Basel III and Dodd-Frank, which will moderate some new construction by requiring sponsors to contribute a higher percentage of equity in new developments than in previous growth cycles.
Whether the Federal Reserve raises the Federal Funds rate in December as expected, or if it waits until the first quarter of 2016, it will almost certainly happen sooner rather than later. If and when the rate hike does occur, it will most likely be done at a gradual and measured pace. Although rising interest rates theoretically do put downward pressure on asset values, the commercial real estate market is poised to continue to thrive in the near-term.
The author, Brandon Wilhite, is a Senior Director in the Dallas office of Metropolitan Capital. Brandon can be reached at email@example.com or 972-267-0600.