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How Will the Fed’s Decision on Interest Rates Impact Commercial Real Estate?

by Brian Kriter, Executive Managing Director, Americas Business Development Lead

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Why did the Fed Funds Rate Increase?

On December 14, the Fed announced a 25 basis point increase (only second increase in 10 years) in a much-anticipate hike. It was time as the U.S. economy is operating at close to capacity (auto sales are at record levels, confidence levels are the highest in 10 years, existing home sales are at a cyclical high, GDP growth in Q3 was >3 percent). However, it’s interesting that the U.S. is tightening when the rest of the world is at full stimulus mode (e.g., countries such as the U.K and Japan are rolling out Quantitative Easing).

What’s going to happen to U.S. 10-year Treasuries?

In this environment, capital flows to the U.S. will accelerate as it is viewed as a “Safety Deposit Box” for capital. The U.S. is growing faster than most other major economies and offering higher yields. U.S. 10-year treasury yields have risen 37 percent since the election (a 75 basis point increase). This increase is attributable to Trump’s economic policies—tax cuts, increase spending on defense and infrastructure will put upward pressure on inflation. If this trajectory continues, it will create challenges for real estate and the economy overall. However, structural forces, such as demographics, will keep downward pressure on long-term rates, which are what matter for real estate. People age 50 and over are the fastest growing segment of the population globally, and their demand for U.S. Treasuries will be going up, not down. As this age cohort turns more conservative, a 2.5 percent yield on the U.S. 10-year will be attractive compared to government debt in Europe and other markets.

What about Cap Rates?

A common held belief is a direct positive correlation between interest rates and cap rates. However, this is an oversimplification, and there have been time periods in the past when there was no statistical correlation between them at all. This correlation ignores what drives Net Operating Income (NOI) growth. Usually interest rates rise when the economy is growing, which put upward pressure on rates and downward pressure on vacancy. When these fundamentals occur, cap rates usually compress. When the economy is growing, the appetite for risk and debt also increase, which drive real estate values higher. Having said this, rising interest rates have already put pressure on certain assets/markets resulting in a 5 percent correction in these markets as interest rates rise faster than NOI growth. When stronger NOI growth kicks in, values will recover within the next 6-9 months.

What will 2017 look like?

There will continue to be tremendous demand for commercial real estate as there is currently $250 billion in capital allocated to real estate that has not been deployed. The value of something is what someone is willing to pay for it, and a huge function of what someone is willing to pay is how much they have to spend.

It is also important to look at the markets from a global perspective. Cap rates on prime office buildings in cities such as Hong Kong, Paris and Tokyo are only 2-3 percent. Should these markets command a cap rate premium to prime office buildings in cities such as New York, Los Angeles, San Francisco, and even Toronto? The prospects for rent growth in Hong Kong, Paris and Tokyo isn’t any higher than the prospects for prime assets in gateway cities in the Americas.

The U.S. is also experiencing record levels for office-using employment, which has lowered office vacancy rates in the U.S. in each of the past six years. New supply (currently at just over 2 percent of existing inventory) is expected to flatten the declining curve for vacancy, but not result in an increase in vacancy. Cushman & Wakefield’s research department tracks 87 office markets across the U.S., and the five largest markets account for 20 percent of the inventory but 38 percent of new supply because these top markets each have vacancy below the national average. Rent growth has also increased an average of 5.5 percent in the past 12 months across these top 87 office markets. Based on these fundamentals, real estate assets with lease rollovers in the next few years, along with value-add assets in good markets, should be good bets.

What about Canada?

Canada’s commercial real estate market will continue to be a magnet for foreign investors. Cushman & Wakefield’s Valuation & Advisory group has advised foreign investors on over $3 billion worth of commercial real estate investments in Canada in 2016. These investors are attracted to Canada because we offer a stable government, attractive returns and relatively good growth prospects compared to other stable countries, and from a currency standpoint, our assets are “on sale.”

Kriter_Brian_AMER_May2014Brian Kriter is an Executive Managing Director and the Americas Business Development Lead for our Valuation & Advisory team.  Brian leads a team of 60 professionals located in 8 offices across Canada and also works to proactively help owners, investors and lenders with their global valuation needs.

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