In Interest Rate Hike, Focus on the Long Term

Commercial real estate will not lose momentum in the wake of the Federal Reserve’s increase in interest rates. Indeed, industry veterans argue it’s vital to focus on the long term, and on the declining 10-year Treasury rates.

In a long-anticipated move, the Federal Reserve last week raised interest rates for the first time since June 2006—a watershed decision that sets the global economy on a new course, one that’s likely to lead to more positive returns for U.S. real estate.

While commercial real estate investment managers and institutional investors will see little immediate impact from the quarter-point increase in the federal funds rate, the hike expressed the Fed’s confidence that the U.S. economy, while not booming, is strong enough to withstand—and justify—higher borrowing costs. That bodes well for property markets.

“Real estate is in a ‘Goldilocks’ environment,” says Christopher Macke, managing director of research and strategy at American Realty Advisors.

First, he says, there’s some volatility in financial markets: “Not enough that it scares away investors, but enough that investors value the relative stability of real estate.” Second, “we’re still in a low-yield environment, and real estate can deliver a healthy premium to fixed-income alternatives.”

That premium, he continues, “will provide future support for real estate pricing and, specifically, cap rates.” Macke notes that while commercial real estate might be enjoying a “Goldilocks” moment, all good stories come to an end, and investors can’t be complacent.

How long real estate can maintain that relative attractiveness is a major question, and last week’s decision clears the way for a clear-eyed assessment. “Now that the Fed has finally done the first hike, we can focus on what really matters, and that’s the longer-term arc of the increase,” Macke says, noting that future increases should happen gradually.

But he argues that it’s essential for investors to differentiate between short-term rates and the 10-year Treasury rate—the key benchmark for real estate financing that declined in the run-up to last week. Macke notes that the prior three times the Fed raised interest rates, the 10-year Treasury rate increased at one-third the pace of increases in short-term rates.

Slower global economic growth will also naturally limit the pace of future U.S. rate increases. “It’s like the Fed is in a canoe with three other people who are all paddling in the opposite direction,” he says.

Central banks in the European Union, Japan, and China are easing monetary policy to boost their economies, and increasingly divergent central bank policies are likely to cause the canoe to become unstable.

In fact, the U.S. dollar’s strength and steady economic growth are already attracting capital into U.S. real estate, providing a major source of support for prices while keeping cap rates in a downtrend. That reflects an increasing preference for lower risk and safe haven assets, not least in the U.S., Macke says, a trend that’s set to accelerate in 2016.

And while future interest rate hikes are expected, there’s “significantly more room to move before we begin to see real pressure on cap rates,” says Spencer Levy, head of research for the Americas at CBRE Group.

“Certain markets may be more susceptible than others to interest rate increases,” he says. But overall “the flow of international funds, combined with domestic pension funds’ large pools of capital allocated to commercial real estate but unspent, will outweigh any potential increase in the cost of capital.”