On June 13th, the Federal Reserve pulled the trigger on another 25-basis point rate hike to 1.75% from 1.50% for the Fed Funds Rate. The result is higher short-term interest rates on most commercial loans. This was widely expected and is part of the Federal Reserve’s stated policy of raising interest rates as the economy grows and performs well. The only real question being debated is how many additional rate increases the Federal Reserve will execute in the next 6 months. Some say one more; others say two.
What are the implications for commercial real estate investors? Most experts argue that the most recent rate hike was already baked into strategies for many investors. Theoretically, higher capital costs usually result in buyers who are willing to pay less for properties with all other variables being equal. Said another way, increasing interest rates usually beget increasing capitalization rates. On the other hand, Cap Rates have proven to move for various reasons, with capital costs being only one part of the equation. Growth in the economy and the prospect for rent growth also factor into resultant Cap Rates.
While the velocity of transaction volume may have slowed down somewhat since the start of the year, Cap Rates really haven’t increased over that timeframe. One reason is that long-term interest rates (often pegged to the 10-year US Treasury Rate) haven’t really moved that much. The resulting flat yield curve makes short-term borrowing and long-term borrowing similar in pricing. For example, the current Wall Street Journal Prime Rate is 5.0% and many 10-year fixed-rate loans are being quoted at or near 5.0% as well. While unusual, it helps explain why buyers still appear to be ready to pay steady Cap Rates in a rising short-term interest rate environment.
While the 10-year US Treasury Rate has fluctuated between 2.77-3.11% since February of this year (currently it stands at 2.86%), spreads over the Treasury have in many cases tightened to result in fairly stable long-term borrowing costs. Coupled with slowing, but still growing rents in many asset classes and a strong outlook for growth in Gross Domestic Product for the national economy, investors are still willing to pay consistently high prices for stable real estate properties. In short, it remains a bit of a seller’s market.
Despite some predictions for a rise in the 10-year US Treasury Rate of between 20-50 basis points over the next 18 months, there may still be some room for lender credit spreads to tighten resulting in relatively similar long-term borrowing costs over that time frame. The real question is what will happen if the short-term rates increase more than long-term rates? An increasingly flat yield curve historically portends a recession. Steadily increasing short-term borrowing, typically affecting construction borrowing costs, will likely slow down the pace of new construction starts. How will this all affect the national economy? Talk to 10 economists and you will get 10 different answers. There are simply too many variables currently to have a majority consensus. The bottom line is that it is still a historically good time to be a borrower of fixed-rate debt for quality commercial real estate assets even at flat Cap Rates.
The Author, Charley Babb, is a Principal and Senior Director in the Denver office of Metropolitan Capital Advisors. Charley can be reached at email@example.com or 720-530-7939.