As of this writing, The Fed has raised its benchmark lending rate by 25 basis points. Fed Chairman Janet Yellen has hinted at further rate hikes in 2017, and most analysts are expected two more rate hikes this year. What do these moves augur for commercial real estate investing and finance in the year to come, and beyond?
The bottom line: the rate hikes are, and will be, in response to good economic news.
After moving cautiously for years, the expected increases in the benchmark lending rate mean a deep conviction that the economy has approached a full recovery, and is operating at or near productive capacity. It’s important to keep in mind that the anticipated rate hikes are in response to positive economic indicators – sustained (if gradual) GDP growth, robust job creation, improved consumer confidence, and unemployment dropping below 5% as the economy approaches the natural rate of employment. Of course, this is all good news for CRE investors – these factors should all serve to buoy demand for multifamily, office, and industrial commercial real estate.
Any time interest rate hikes are on the table, inflation should be monitored as well.
Classic economic theory tells us that interest rates and inflation eventually move inversely, as higher yields push up the savings rate and reduce spending volumes in the economy. However, it’s likely that the underlying growth and consumer confidence driving the Fed’s decision will also mean higher rates of inflation in the short and medium term, as a greater velocity of money pushes prices upward. With regards to inflation, the Fed’s rate increases will be ameliorative rather than preemptive. With respect to commercial real estate investing, inflation is nothing to be afraid of, as the asset class provides a natural hedge in the form of rising rents. However, it is a factor to be aware of – managers should be ready, able, and willing to push rents upward in response to rising interest rates. Flat long term leases are suboptimal in this environment, and won’t create as much value on a relative basis. As you evaluate potential investments, be sure that the real estate companies you consider investing alongside have given proper consideration to inflation.
Speaking of cap rates…
It’s often assumed that cap rates and interest rates move in lockstep – in other words, that rising interest rates will have a negative effect on pricing and increase cap rates, all else being equal. The data doesn’t exactly corroborate this theory – while it’s true that cap rates and interest rates (using 10 year treasury yields as a proxy) show a modest correlation of 0.7*, but correlation does not imply causation – capitalization rates are influenced by a wider network of variables beyond interest rates, including real estate market fundamentals, investor appetite for risk, and capital flows.
The big lesson here is that any increase in cap rates stemming from a rate hike (as consequence of increased cost of capital) is likely to diminish over time. The effect of an increased “exit cap rate” flattens out throughout the course of longer investment horizons**, as the compounding effect of net operating income (NOI) looms larger and larger. In other words, rising interest rates may have some impact on cap rates, but it should not be substantial in the long run – real estate investors can protect themselves against the risk of rising cap rates by pursuing longer-hold projects.
Don’t forget about secondary markets.
When the Open Market Committee met in February, Fed Chief Janet Yellen noted that there are some concerns of frothiness in high-density gateway cities, where historically-high volumes of foreign investment and oversupply have perpetuated cap rate compression. With a rising cost of debt capital, non-gateway “18 hour” cities are looking better and better by comparison for real estate investors seeking yield. Fortunately, there are a handful of secondary markets – such as Seattle, Minneapolis, Raleigh, Austin and Denver – experiencing above-average overall population growth and job growth, driven by an influx of millennial professionals who will drive multifamily, retail, and office demand for the foreseeable future.
For investors in online real estate platforms like EQUITYMULTIPLE, the chief consideration should be whether the platform’s real estate team is considering these factors, and whether the originators behind the platform’s constituent projects have experience through business cycles, and can make wise investments and management decisions in a fluid interest rate and regulatory environment. As always, our Investment Team considers a wide array of macro factors when sourcing and evaluating potential investment opportunities. These considerations, and many others, decide whether a project makes it through to further stages of diligence.