Article originally posted on National Real Estate Investor on June 12, 2018
The mid-year rate hike is already baked into strategies for most investors and shouldn’t cause any major surprises or hiccups on pending deals.
The rate hike would come on the heels of a similar bump in March that raised the Fed’s benchmark interest rate to a range of 1.5 to 1.75 percent. The bigger question for those reading the tea leaves on higher interest rates is what’s ahead for additional increases in the second half of the year, and how the rising rate environment might impact investment strategy, sales transactions, cap rates and pricing.
“I think it is all but certain that we are going to have a rate increase after the June meeting,” says Heidi Learner, chief economist at real estate services firm Savills Studley. The jury is still out on whether that will be followed by one or two more rate hikes in the second half of the year, she adds. The Fed raised rates three times in 2017. “So there is clear precedence for them to not move rates at every quarterly meeting following their economic projections.”
Based on pricing expectations coming from federal funds futures contracts, confidence in the days preceding the June Fed meeting was high that another rate high was imminent with a 94 percent probability; followed by a 67 percent chance of another increase in September and a 36 percent chance of an increase in December, according to real estate services firm Cushman & Wakefield.
Low inflation is one reason the Fed has been slow to move rates higher, and the Fed’s most recent forecast is for a modest level of inflation growth at 2 percent in 2019. What will likely happen is that the Fed will pencil in another rate hike after the June increase, and if for some reason there is a bigger spike in inflation, it will have the ability to raise rates twice in the second half of the year, notes Learner.
Implications for CRE
The mid-year rate hike is already baked into strategies for most investors and shouldn’t cause any major surprises or hiccups on pending deals. The Fed increases influence short-term debt rates, while the 10-year Treasury is used to price long-term, fixed-rate debt.
In theory, higher capital costs could result in bidders opting to pay less for properties, which could create some upward pressure on cap rates. Yet cap rates move for various reasons, with capital costs as only part of the equation. “Cap rates are more driven by one’s view of growth in the economy and growth in rents than interest rates alone,” says Steve Kohn, president of Cushman & Wakefield equity, debt & structured finance. Expectations for rising rental rates could keep pressure on cap rates in some sectors and regions.
“We have seen a bit of a slowdown in transaction volume, but we haven’t seen an upward move in cap rates over the last six to nine months as 10-year yields have essentially moved from 2 percent to 3 percent,” adds Learner. Although cap rates have moved from 2016 lows, the recent increases that have occurred have been slight. “I think a lot of investors are taking a wait and see view, not so much because of rates and what that implies for financing, but more because of the prospects for further rent growth,” she says.
Deal volume for the first four months of 2018 was down 1 percent from a year earlier, with volatility in the 10-year in April contributing to much of that decline, according to real estate research firm Real Capital Analytics (RCA). Cap rates remained largely unchanged through April, while industrial and seniors housing sectors saw further declines in cap ratescompared to 2017, with a drop of 40 and 60 basis points respectively due to high demand for those asset types.
