Wednesday’s decision by the Federal Open Market Committee (FOMC) — the branch of the Federal Reserve Board that determines monetary policy — to raise the benchmark federal funds rate for the first time in almost 10 years raises an important question: What impact will this increase have on commercial real estate?
The rate hike will have a “minimal impact,” predicts Jeffrey Rinkov, CEO of commercial real estate brokerage firm Lee & Associates.
“Based on a strengthening and stabilizing economy, I believe this was a logical move by the Fed,” says Rinkov. “While the Fed is driven by data, I think this signifies its belief that the economy can operate in an environment with a normalizing monetary policy. Relevant to real estate investment, long-term interest rates should remain at historical low levels, which will continue to incentivize investment.”
Prior to Wednesday, the Fed kept the federal funds rate — an overnight interbank lending rate — in a band between zero and 0.25 percent since December 2008, when it lowered rates in the midst of the Great Recession.
On Wednesday, Federal Reserve Board Chairwoman Janet Yellen announced that the FOMC had voted to raise the federal funds rate by a quarter percentage point to between 0.25 percent and 0.50 percent.
In the wake of Yellen’s announcement, the research team of Cushman & Wakefield released a report titled, “The Fed’s Decision: Implications for Commercial Real Estate.” (The team is comprised of Kevin Thorpe, chief economist; Rebecca Rockey, head of forecasting; and Ken McCarthy, principal economist.)
Pros and Cons
Like every other asset class, the commercial real estate sector has benefitted from the Fed’s massive injection of liquidity into the economy over the past seven years, the Cushman & Wakefield research team emphasizes.
“Prices have generally recovered. Indeed, for some property types and local markets prices now exceed pre-recession peaks. As the FOMC moves to normalize interest rates, there is some concern that rising rates will reduce investor demand for commercial real estate as lower-risk investments (such as U.S. Treasury bonds) begin to look more attractive,” the Cushman & Wakefield report states.
However, there are three reasons to expect that commercial real estate prices and returns will continue to be attractive even in a rising interest rate environment, contends Cushman & Wakefield.
- The Fed’s policy moves, while important, are not the sole driver of long-term interest rates. Inflation, a major driver of longer-term yields, is expected to remain low over the next 10 years. That, combined with what will eventually be a slow unwinding of the Fed’s balance sheet, will keep downward pressure on the 10-year Treasury note.
- Improving economic conditions helped drive the Fed’s decision. The FOMC is raising interest rates in part because labor markets are strong. Since the end of 2013, nonfarm payrolls have increased by slightly more than 5.5 million jobs. It is likely that 2014 and 2015 will be the strongest back-to-back job growth years since 1998 and 1999.
This job growth is a major factor driving improved leasing market fundamentals across the United States. As space is absorbed, vacancy is falling and rents are rising across property types. In the third quarter of 2015, the national office vacancy rate fell to its lowest level in seven years (14.2 percent).
- Against the background of weakness in the global economy, the U.S. continues to stand out as the safest of safe havens and is attracting massive capital flows from around the world. With many countries’ central banks (Eurozone, China, Japan, India) still implementing aggressive monetary policies, some of the newly printed capital will gravitate to the U.S. and continue to support real estate pricing.
The initial short-term interest rate hike by the FOMC is largely symbolic and the action is just the first step in what will likely be a lengthy process of monetary policy normalization, according to Cushman & Wakefield.
What Does History Show?
Historically, a rising federal funds rate has initially coincided with improving commercial real estate markets and rising property prices, the Cushman & Wakefield research team points out. For example, the last few economic cycles in which the Fed has tightened monetary policy have been accompanied by rising office occupancy rates.
From 1993 to 2000, the federal funds rate rose from 3.0 percent to 6.5 percent. Office occupancy during that period jumped from 79.6 percent to 90.9 percent. Similarly, from 2003 to 2007 the federal funds rate rose from 1 percent to 4.25 percent and office occupancy increased from 80.5 percent to 87.1 percent.
Typically when the Fed begins raising rates, the clock for when to expect the next economic downturn to occur begins, according to Cushman & Wakefield. Post-World War II, nine of the last 14 recessions have occurred during a time when the Fed was tightening monetary policy. The time between when the Fed first begins to tighten policy to when a recession occurs is typically two to three years.
However, the Fed’s current mantra is that this tightening cycle of monetary policy will be more gradual than normal, the Cushman & Wakefield report states. “Other factors —monetary stimulus still occurring in other economies, the slow and evolving nature of this recovery in general — do suggest there is a fair amount of runway left in the current expansion. We would anticipate that office occupancy and values will continue to increase for the majority of building assets over the coming year, even in an environment with higher interest rates.”
— Matt Valley