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Interest Rates vs Cap Rates: Will Fed Rate Hikes Put More Pressure on Pricing?

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.

It seems almost a “sure thing” that the Fed will pull the trigger on another 25-basis point rate hike this week at its June 13th meeting.

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 rates compared to 2017, with a drop of 40 and 60 basis points respectively due to high demand for those asset types.

“I think it is somewhat asset class specific, but it is fair to say that there hasn’t been an overwhelming amount of upward pressure on cap rates to date,” adds Learner.

Capital costs remain historically low

The 10-year Treasury has been somewhat volatile in 2018, which is related to volatility in the stock market. During May, the 10-year dropped from a high of 3.11 to 2.77 before settling back to hover right around 3.00 percent. “I do think over time we will continue to see a rise in 10-year rates, although I certainly don’t think the magnitude of the rise is going to mirror the increase in fed fund rates,” says Learner.

One reason the 10-year rate could remain low is because the U.S. is still benefiting from a lot of foreign capital flows. However, absent any unexpected economic or geopolitical shocks, the 10-year rate could rise by another 25 basis points this year, predicts Learner.

According to the ULI Spring Real Estate Consensus Forecast, the 10-year is expected to rise slightly, to 3.1 percent by the end of the year, followed by an increase to 3.4 percent for both 2019 and 2020. Meanwhile, the forward curve on the 10-year Treasury will likely stay relatively flat over the next 10 years at 3.02 percent.

Yet investor opinions on what’s ahead for the 10-year remain mixed. “We have certain clients who believe the 10-year will remain relatively flat, while others are more conservative and are rushing to lock-in rates ahead of higher rates,” notes Kohn. Even with higher rates ahead, some clients want to stay short-term to maintain flexibility to be able to alter debt in the future, either to increase it or to be able to sell an asset unencumbered, he adds.

It is also important to note that there is still room for lender credit spreads to tighten if interest rates go up, adds Chris Moyer, a managing director at Cushman & Wakefield equity, debt & structured finance. Credit spreads on 10-year fixed-rate money range from 110 to 150 depending on leverage. If the 10-year is going up because the economy is improving, and people feel good about the credit risk of real estate, there is no reason that AAA-rated loans can’t tighten by another 20 to 40 basis points, notes Moyer.

“So, it depends on why Treasuries are moving. If it is moving for a positive economic reason and people feel like there is a lot of runway in the economy, then the credit spread should adjust down accordingly to compensate for the increase in the treasury rate,” says Moyer.

The real key to watch for commercial real estate investors going forward will be the pace of interest rate increases still ahead. The negative ripple effects from rising rates often have to do with the speed of those increases. “If rates rise moderately over time, I think investors deal with that better than if there is a sudden major movement,” says Kohn.

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