The Fed finally moved to raise its key interest rate by 0.25% in December, which is the first increase in almost 10 years. It signals a strengthening economy that has been slowly gaining steam. Since the recession ended, the unemployment rate has been cut in half. Today, corporate profits are on the rise and most hope that income levels will soon follow that trend. Despite other economic indicators such as stagnant inflation, a strengthening U.S. dollar and global economic headwinds, most economists generally agree that the increase was warranted. Future increases are anticipated to be tepid and measured.
The federal funds rate is an increase in the cost of borrowing between banks for short terms loans. This increase is then passed along into other short term vehicles used by corporations and households. The increase will ultimately impact long term borrowing. Long term borrowing rates, in turn, will begin to affect asset prices. During the crisis, the Federal Reserve purchased a large amount of long term bonds and mortgage backed securities which may ultimately stymie the efficiency of rate increases on long term debt.
In any event, this interest rate move by the Fed signals a paradigm shift for commercial real estate investors. For the first time in a decade, we now find ourselves in an environment with rising interest rates – albeit slowly rising rates. What does this mean for commercial real estate investments?
Interest rates impact real estate investment value. The generally accepted view is that rising rates negatively impact commercial real estate value. However, there are a myriad of issues that ultimately impact commercial real estate valuation upon closer review, including but not limited to economic growth, inflation, supply and demand, and capital flows.
As mentioned earlier, the U.S. economy appears to be strengthening and on solid footing. In addition to a drop in unemployment from the peak during the recession, there is positive news when looking at nonfarm payrolls which have experienced consecutive year over year growth in 4 of the last 5 years. Also, new residential housing starts have realized a sustained marked improvement year over year since 2009. A stronger economy bodes well for commercial real estate as a viable and strengthening asset class.
There is a strong correlation between interest rates and inflation. They tend to rise and fall together. In fact, the Fed will raise interest rates as one of the many ways to combat climbing inflation. Long term leases that encumber commercial real estate investments typically include some type of annual CPI adjustment. Short term leases can self-adjust accordingly at lease expiration. Thus, real estate is generally a great hedge against inflation. Inflation today is nonexistent and therefore was not a factor in why the Fed chose to raise rates. Low inflation coupled with annual lease escalations signal positive returns for investors despite an uptick in rates.
For obvious reasons, supply and demand is a critical variable in determining the value of real estate in a given market. Understandably, it changes from market to market. That being said, carefully looking at national indicators allows us to understand, at a macro level, salient data which can help lead us to conclusions. Upon review of multiple data sources provided by real estate analytic firms, absorption has been steady and new product is limited in most asset classes with the exception of multifamily which has surged in recent years in major markets. Assuming economic growth remains steady, absorption should continue and dictate the need for additional supply and construction.
Capital flows into the real estate sector remain robust. Private equity firms, non-traded, and publicly traded REITS have been active with their investment in real estate concerns over the last decade. Whether these investments are in real estate related service firms or the assets themselves, this trend is anticipated to continue. In addition, foreign investors have been drawn stateside to deploy their equity. Given further economic turbulence in the global market, this trend is also anticipated to continue. With so much equity to deploy in limited assets, commercial real estate valuation should increase.
Commercial real estate investors should not be overly concerned about the rising interest rate environment we now find ourselves in. Even if the Fed chooses to raise rates, using a measured approach over the next few quarters, it remains to be seen what will happen to long term interest rates based on the amount of long term bonds and mortgage backed securities held by the Treasury. All of this coupled with the factors outlined above indicates a positive environment for commercial real estate investments and sustained value growth in the foreseeable future.
As always is the case, investors should be judicious in the underwriting of any asset and understand all of the risks and opportunities that each presents. Working with a trusted commercial real estate investment advisor to help understand the many facets of a real estate investment is strongly advised.