CoStar | How Will Fed's Plan to Shift from Negative Rate Environment Impact Real Estate Valuations

October 30, 2017

By CoStar News Staff (news@costar.com)

How Will Fed's Plan to Shift from Negative Rate Environment Impact Real Estate Valuations?

Even as Fed Raises Interest Rates, CRE Market Plows On. "It's Really Hard to See How This Party Ends" At numerous times over the past several years, rising Treasury yields have prompted commercial real estate investors to speculate how the end of historically low interest rates would influence property values. Invariably the yields reversed course -- even after the Federal Reserve began in late 2015 to 'tighten' monetary policy -- and capitalization rate compression continued.

But investors are once again pondering the question amid the Fed's announcement earlier this month that it would begin to unwind its nearly $4.5 trillion balance sheet this month. The Fed also indicated that it expected a steady rise in federal funds rate in the coming years, including a possible hike of 25 basis points in December that would take the benchmark rate to a range of 1.25% to 1.5%.

The actions are expected to move real interest rates into positive territory, representing a "significant shift" from the negative rate environment that has fueled the recovery, according to Wells Fargo economic commentary issued in September.

by Joe Gose, Special to CoStar News Real estate observers suggest that as long as the Fed remains methodical and transparent, interest rates will likely inch up in an orderly fashion and won't shock the market into a credit freeze. Additionally, waves of real estate equity and debt searching for yield should continue to fuel the low cap rate environment, albeit in a choppier fashion, they add.

"If I'm a buyer and I know my return on a piece of real estate is lower than it was a year ago, but there are no better investment alternatives, what am I going to do?" asked William Hughes, senior vice president for Calabasas, Calif.-based Marcus & Millichap Capital Corp., a real estate finance intermediary.

Given the lack of alternative, Hughes added, "Eventually, I’m probably going to go into the marketplace and participate."

ROLLINSEven contrarians like Jay Rollins, managing principal of Denver-based JCR Capital, admit that it's tough to envision what could derail the market. Even so, Rollins said his firm, a debt and equity provider serving middle market property investors, is more frequently turning down investment opportunities after assessing the property's performance under stressed interest and cap rate scenarios.

"It's really hard to see how this party ends," he said. "Investors are looking into the future and trying to see how property values drop 20% to 30%, but at this point nobody sees disruption. I certainly don’t see it, and I'd like to. We do better in those environments."

While real estate experts say they don’t necessarily welcome higher interest rates, they acknowledge that the Fed needs to tighten and unwind so that it has tools to use in the next recession. With that in mind, the Fed's timing is particularly critical.

Copyright (c) 2017 CoStar Realty Information, Inc. All rights reserved.

CONTINUED: How Will Fed's Plan to Shift from Negative Rate Environment Impact Real Estate Valuations?

SEVERINOThe current eight-year expansion is less than a year away from becoming the second-longest growth cycle in the post-World War II era, a distinction that is weighing on the psyche of investors.

Plus, rising interest rates tend to dampen economic activity in general, said Ryan Severino, chief economist for Chicagobased brokerage JLL. That can lead to a softening of real estate fundamentals, the real culprit that drives up cap rates, he noted.

"The Fed is going to have to be a little bit careful about pushing too hard on interest rates relative to the underlying growth of the economy," Severino said. "I don't know when the next recession is coming, but I’m willing to bet we’re closer to it than we are to the previous recession."

Severino also questioned whether in fact the Fed would raise the benchmark rate in December given its policy to rely on employment and inflation data. While the former supports a hike, the latter has lagged the Fed's annual 2% target.

Other variables weighing on real estate’s fortunes include a lingering price standoff between buyers and sellers, tax policy, the U.S. debt load, and potential geopolitical events.

With so many potential forces at work in the market, observers downplay the effect that incremental interest rate increases alone will have on investment strategies and cap rates. What’s more, the degree of impact will vary by investor type, hitting private buyers who depend on a load of leverage harder than institutional buyers, who typically need little or no debt, they say. Like JCR Capital, however, some investors are becoming more cautious.

FIELDS"A number of my clients that borrow from typical lenders are trying to get to market sooner rather than later because they do anticipate a hike in rates," said Kenneth Fields, a real estate attorney with Greenberg Glusker in Los Angeles. "I’m seeing more of a preference to take fixed-rate terms than to take a risk on an adjustable."

Real estate observers only have to recall the days following last November’s election to see the results of a rapid interest rate rise. The 10-Year Treasury yield’s run-up of some 80 basis points to 2.6% from early November to mid December -punctuated by a spike of 50 basis points over two weeks -- and the Fed’s December rate hike put the brakes on transactions. The lull extended into the first quarter this year, they acknowledge.

In some cases, financing already cemented for acquisitions crumbled as concerns about exit cap rates surfaced.

Subsequently, observers say, prices have begun to move sideways or even slip over the last few months even as the 10Year Treasury yield has roughly hovered between 2% and 2.4%. The latest CoStar Commercial Repeat Sales Indices reveals that pricing trends for larger investment-grade assets have largely experienced a slight dip or little-to-no appreciation over four months through August even as smaller properties in secondary and tertiary markets continue to trade at higher prices.

RAIMANFear of higher rates as they relate to real estate has been apparent in the equity market for some time, noted Lawrence Raiman, CEO and portfolio manager for New York-based LDR Capital Management, a buyer of preferred REIT shares. The S&P 500 closed the third quarter up roughly 14% for the year versus a return of about 3% for the Dow Jones Equity REIT Index.

"Generalist investors have become nervous about interest rates," Raiman said, "hence they’re not putting any money into the (REIT) group."

HUGHESConversely, North Korea’s nuclear ambitions and other geopolitical threats could drive investors to the perceived safety of U.S. treasuries, which could keep a lid on interest rates despite the Fed’s actions, Marcus & Millichap's Hughes explained. But such events also have perhaps the biggest potential to disrupt the economy, he added.

"There are a lot of things at work in this market," Hughes added. "We’re of the opinion that this cycle can run for a while, but I think investors are coming to the realization that there’s not going to be a simple end to it."

Joe Gose is a freelance business writer and editor based in Kansas City.

Copyright (c) 2017 CoStar Realty Information, Inc. All rights reserved.