By Kevin Thorpe, Chief Economist
The Fed announced it would raise the Fed funds target range by 25 basis points (bps) December 14 in a much-anticipated hike. The vote to raise interest rates was unanimous. All Federal Open Market Committee (FOMC) voting members agreed this was the right thing to do for the economy at this time.
Why now? In some ways, if not now, then when? By most metrics, the U.S. economy is performing pretty well, and is gaining momentum. Gross Domestic Product (GDP) growth was more than 3% in Q3; the consumer is buying more; vehicle sales are hovering in record territory; existing home sales are at a cyclical high; confidence levels are the highest in nearly a decade; and the Fed has also achieved its dual mandate on maximizing employment (unemployment is now 4.6%) and stabilizing inflation (the consumer expenditures deflator trending at 1.7%, just below the Fed’s 2.0% target).
For a global context, it is worth noting that the Fed is tightening at a time when much of the rest of world is still in full stimulus mode, with many central banks still very concerned about deflationary pressures. Many outside of the U.S. are keeping rates at zero or even negative in some cases, and some are still implementing their own versions of quantitative easing. That the Fed is raising rates is an indication that the U.S. economy is in a much healthier position relative to most other countries. This divergence in policy is likely to pull even more capital to the U.S., and it also gives the Fed more ammunition for the next economic downturn, whenever that may come.
Long-term interest rates are what to watch right now. The 10-year treasury yield has already jumped nearly 75 bps since the November elections. If you are in real estate, it is hard to feel comfortable with this latest move. If this upward trajectory that we have seen over the last few weeks were to continue, it would create all sorts of challenges for the U.S. economy and for our industry. However, for a variety of reasons (aging demographics, low global yields, global volatility, etc.), interest rates are likely to settle down. Nevertheless, gone are the days of the U.S. treasury yield falling below 2%. Between 2-3% is most likely for 2017, and 3-4% for 2018.
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Some fear that if interest rates rise, then cap rates have to rise. Therefore, according to our trusted equation her and all else equal, property values have to fall. Although that fear is certainly understandable, it’s also an over-simplification because it ignores all the other variables that drive net operating income (NOI). The very fact that interest rates are rising may signal very good things for future NOI.
History teaches us a couple things. First, the relationship between interest rates and cap rates is overstated. There have been periods where interest rates go down and cap rates go up, when interest rates go up and cap rates go down, and when interest rates and cap rates move in tandem. It is certainly not a given that when interest rates move upwards, cap rates must also.
History also tells us that economic growth is really important in driving property values. The relationship between National Council of Real Estate Investment Fiduciaries (NCREIF) total returns and GDP is strong—in fact, much stronger than the correlation between cap rates and treasuries, which makes sense. If interest rates are rising for the right reasons, namely because of stronger economic growth, then all of the factors that drive NOI—lower vacancy, higher rents, stronger appetite for risk, stronger appetite for debt—should drive CRE values up, even in a gradually climbing interest rate environment. Short-term, there will be some downward pressure on values because it will take time for NOI growth to catch up. But longer-term, stronger economic growth kicks in, NOI strengthens, and then values will pick up again.
That said, it wouldn’t be surprising if we had another choppy first quarter. Whenever there is a change in U.S. monetary policy, particularly coming off of a period of seven years of the same zero-rate policy, this has ripple effect on the global financial markets. Credit markets, currency markets, and Commercial Mortgage-Backed Security (CMBS) markets will need to adjust. We may be looking at an uncomfortable start to the new year, but I wouldn’t rule out a bond rally in Q1, which we have seen the last couple of years due to heightened volatility. As we have seen for the past several years, the first quarter is typically not a precursor for how the rest of year will go, which is usually much better.
Making investments at this maturing stage in the cycle is challenging. There is probably not a cap compression play to be made anymore. Cap rates, the current return on a property, have already fallen substantially since this cycle began, and there is not a lot of room for further decline. But I think the opportunity is this: few if any are calling for an economic downturn anytime soon. If anything, consensus is forming in the opposite direction, and the U.S. economy is going to heat up even more. Shifting your real estate strategy in this cycle based on short-term volatility, or even what economists have been saying about interest rates, has been the wrong call to make. Investors that pounced on the volatility and stayed aggressive have generally done pretty well for themselves over the last several years. And if the growth scenario plays out the way most think it will, then higher beta markets—markets where prices tend to rise more than the national average that are big enough to have liquidity—are probably good bets. Assets with leases rolling over within a couple of years are probably good bets, and value-add in solid markets are also probably some pretty good bets.
What short- or long-term impacts do you predict from the Fed’s recent actions?
Kevin is Cushman & Wakefield’s Global Chief Economist, focusing on global economic trends and forecasts. He and the firm’s worldwide research team produce studies and statistics on topics affecting the global and U.S. economy, capital markets, finance, leasing fundamentals, property and project management and factors that affect supply-demand fundamentals in commercial real estate. Kevin has developed several econometric models to predict market trends, is a member of the National Association for Business Economics (NABE), and has authored numerous studies and survey reports. In 2014, he was recognized as the nation’s most accurate economic forecaster with the NABE’s Outlook Award.