After slowly rolling out interest rate increases since the end of 2015, the Federal Reserve announced an increase of one-quarter of a percentage point this March, with at least two more increases expected in 2018. While rates are expected to rise at a modest level, commercial real estate developers, lenders and investors are keeping a close watch on any ripple effects in the industry—especially when it comes to property values.
Why the Increases?
The Great Recession brought rate increases to a screeching halt. Now that we’re in the ninth consecutive year of fairly robust economic growth, and given the expected impact of the $1.5 trillion tax cut that took effect in January, Fed officials are convinced that the economy can weather a steady trickle of rate increases. Additionally, the Fed wants to maintain control of inflation without hindering the further expansion of the economy. In fact, at the time of the last increase, Fed officials hinted that the pace of increases might be more aggressive than what was initially projected.
Impact on Commercial Real Estate
Why the concern? In a broad sense, rate increases often make it more expensive to develop new projects and refinance certain debt. When borrowing becomes more expensive, the real estate industry tightens. And, as real estate investors know, rapid interest rate increases can increase capitalization rates and lower property valuations. Any time rates increase too fast – or too often – property values can be impacted. Even when incremental increases don’t directly affect the increases, there can be an overall detrimental effect on the economy, which in turn affects many industries.
There have been some reports of prospective buyers locking in rates for long-term financing. In some areas of the country, more property is hitting the market as owners seek to cash out before historically low cap rates go up as a result of interest increases.
Keep in mind that the spread between cap rates and Treasury yields has been wider than normal, and that has provided the commercial real estate market some breathing space when it comes to higher rates. However, there will be less margin as rates continue to rise, thus triggering the disruption in cap rates.
Too Early to Know
As we mentioned above, the Fed believes the economy is healthy enough to absorb higher rates. A good economy generally has positive implications for a healthy commercial real estate market. Also, the Fed has been very transparent about its plans for gradual rate increases, which has allowed property owners and investors to factor rate increases into their plans.
Historical data shows that interest rate hikes don’t necessarily correlate with lower property values. Other factors, such as supply and demand, transaction activity and the continued health of the economy, must be factored into the equation.
Still, the very idea of interest rate hikes can raise a concern about development opportunities, cap rates, and lower property valuations. Looking into the future, investors and developers may need to prepare for a tightening lending environment and consider long-term rate lock swaps as a strategy to mitigate the increased interest rates.
For now, we do not sense that the moderate rate increases provide a real cause for concern. Consumer spending is positive, unemployment is low, and the economy is sound. Financing costs remain low, and so far, rate increases have not had much of an effect on transaction volumes.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.