Source: CoStar
By: Randyl Drummer
Date Posted: March 22, 2018
Link to Article: Interest Rate Hike

In a widely expected but still worrisome move for commercial real estate investors and financial markets, the Federal Reserve Bank on Wednesday raised the federal funds rate a quarter point from 1.5% to 1.75%, the first of three rate hikes expected by the central bank and the sixth quarter-point increase since the beginning of 2016.

The Fed, in its first policy meeting under new Chairman Jerome Powell, also raised the longer-term “neutral” rate, the level at which monetary policy neither boosts nor slows the economy. In a news conference Wednesday, Powell said that the economy has recently gained momentum and he expects inflation to finally move higher after years running below its 2% historical target.

The Federal Open Markets Committee noted in a statement at the end of its two-day meeting that the labor market has continued to strengthen and that economic activity has been rising at a moderate rate.

The FOMC noted strong job gains in recent months and the exceptionally low unemployment rate, underscoring the central bank’s growing confidence that tax cuts and government spending will continue to boost the economy. Unemployment is now expected to fall to 3.8% this year and 3.6% in 2019, which would be the lowest since 1969.

While the Fed plans to follow a path of gradual rate increases, Powell said policymakers need to be cautious about inflation. The chairman warned that financial market asset prices, including real estate, are high relative to their longer-run historical norms in some areas.

“You can think of some equity prices. You can think of commercial real estate prices in certain markets. But we don’t see it in housing, which is key,” Powell said.

“Overall, if you put all of that into a pie, what you have is moderate vulnerabilities in our view,” the chairman added.

In their Monetary Policy Report to Congress last month, Fed policymakers noted “valuation pressures continue to be elevated across a range of asset classes, including equities and commercial real estate. In general, valuations are higher than would be expected based solely on the current level of longer-term Treasury yields,” the report said.

Although rates remain low by historical standards, interest rate increases remain top of mind for CRE executives this year. In a sentiment survey by law firm Seyfarth Shaw, 80% of respondents expected multiple rate increases, and clearly expect that the increases will begin to weigh on commercial property markets in 2018.

More than one-third, 37%, of those surveyed in February by the Chicago-based firm predicted three rate hikes by the Fed over the next 12 months, up from just 14% a year ago.

CoStar Portfolio Strategy Managing Director Hans Nordby notes that the end of the so-called low-rate environment is going to have an increasing impact on CRE pricing going forward.

While interest rates are going to matter much more to investors, and will likely lead to higher cap rates, Nordby expects only about one-half to two-thirds of the 10-year Treasury rate yield should transfer to cap rates because the spreads between cap rates and Treasury rates are already wide compared to historical levels.

“CRE investors have worried about cap rate increases for the better part of 15 years, and fighting the Fed with the assumption of higher rates has served few well. Those who avoided low-cap-rate deals and bought the best assets have fared very well since the Great Recession,” Nordby said.

“However, those who bought at higher cap rates but took on credit or market risks, such as acquiring Toys ‘R Us stores in sleepy suburbs or less-thriving U.S. cities, those bets probably didn’t fare so well,” Nordby added.

“But today’s (rate increase) is a little different,” Nordby added. “The Fed appears to be on board with higher rates at both the short and long ends of the (yield) curve. Fighting the Fed now means trying to hang on to scary-low cap rates in some of the nation’s largest markets.”

Nordby also points out that many properties may have lower cap rates because their existing leases are at below-market rents, which presumably will be replaced with higher-income leases as they roll over.

However, while many assets have the potential to benefit from this dynamic, properties that are locked into a 20-year lease with a credit tenant that was previously touted for its bond-like stability when interest rates were low may see value decline as interest rates rise, Nordby said.

“Markets like New York City multifamily, which had razor-skinny cap rates and spreads, are now showing weak or negative rent growth. These are the types of assets that are most exposed to interest rate surprises in the next couple years,” Nordby said.