As widely expected by the market, on the 14th of June, the Federal Reserve increased the benchmark Federal Funds Rate by 25 basis points – the 3rd such rate hike since December 2016 and the 4th since the Fed enacted the Zero Interest Rate Policy (“ZIRP”) to stimulate the economy. June’s rate hike brings the Fed Funds Rate to a target range of 1.0% to 1.25%. Additionally, it is expected that the Fed will increase the rate 1 to 3 times during the balance of 2017.
All things constant, rising interest rates result in declining asset values, including commercial real estate assets. In reality, all things are not constant, and despite four rate hikes in the past 18 months, commercial property values have continued to rise. To understand why it is important to consider some of the other factors affecting property values such as:
- Rate hikes by the Fed are a signal that the economy is strong, meaning that demand to lease commercial property is also strong, which translates into rising rental rates, which put upward pressure on property values.
- The current economy is at or near “full employment,” meaning that workers have more bargaining power on their wages. Rising wages, combined with increased cost of construction materials, have resulted in soaring construction prices. In some markets, where construction prices are rising even faster than rental rates, developers are having a hard time justifying the construction risk, resulting in less supply available to absorb growing demand. Without sufficient supply to absorb demand, rental rates rise further and push values as described above.
- Interestingly, rising interest rates may be contributing to rising property values, despite the earlier statement stating the contrary. Of the reduced share of proposed new construction projects, which are feasible due to rising construction costs, increased interest rates may be the deciding factor in projects that were already borderline.
- Banking regulations put in place in response to the financial crisis of 2008 are putting constraints on banks’ balance sheets and limiting the leverage on their construction loans, thereby forcing would-be developers to either invest or raise additional equity. As deleveraging increases the cost of capital on the project, similarly to increased interest rates, some projects become no longer economically feasible.
To an extent, the factors described above are keeping the market in check and preventing overbuilding, which is common in real estate cycles. On the other hand, these factors are often suppressing good development projects which could spur economic growth. Furthermore, this constraint on development is leading to increased housing costs for renters and occupancy costs for businesses. With wage growth and inflation fairly muted so far, the market is questioning the need for further rate hikes by the Fed. Additionally, much of the business community supported President Trump in hopes that a new conservative regime would loosen the regulations on banks, which will hopefully loosen the spigot on new construction activity to accommodate the growing economy.
Metropolitan Capital Advisors has been very active in assisting our clients in obtaining attractive construction financing throughout the current cycle. In spite of a tight construction funding market, during the first half of 2017, our firm has completed over $170 million of new construction loan placements on the hotel, retail, multi-family, self-storage and residential condo projects across the United States. Contact us to benefit from our expertise. http://www.metcapital.com
The author, Brandon Wilhite, is a Senior Director in the Dallas office of Metropolitan Capital Advisors. Brandon may be reached at firstname.lastname@example.org or 972-267-0600.