How Interest Rate Drops Could Affect Commercial Real Estate Investing
Commercial Real Estate
In July 2019, the Federal Reserve cut the federal funds rate for the first time since it began quantitative easing in 2008 in response to the financial crisis. The Fed reduced rates from 2.25% to 2% for several reasons: to support continued economic growth, to insure against the downside risks of trade policy and weak global growth, and to reach the targeted inflation rate of 2%.¹
The federal funds rate is the interest rate at which banks lend their reserve balances to one another. But it also can influence other interest rates such as consumer loans and the cost of financing commercial real estate, which in turn can affect property values.
In this article, we will look at how the recent interest rate drop may affect commercial real estate going forward.
The income approach is one method that investors use to determine property values. This analysis begins with actual or forecasted property income, then subtracts out normal operating expenses to determine the Net Operating Income (NOI) of a property.
Once the NOI is determined, investors then subtract the cost of financing from the NOI to calculate the Net Cash Flow (NCF) of a property. Another way of thinking about NCF is that it’s the money available to investors at “the end of the day” after accounting for management and interest expenses. NCF is in a way similar to dividend payments received from stocks.
One of the benefits of investing in commercial real estate is the use of positive leverage.² For example, let’s consider buying a property selling for a 6% cap rate when the cost of financing is 3.5%. The difference between these two metrics (also known as the “spread”) generates a yield of 2.5%.
Here’s an example of how to measure the financial performance of the investment using the income approach calculation:
A property with a market value of $1 million and an NOI of $60,000 has a cap rate of 6% ($60,000 NOI / $1 million market value). If the cost of financing (or mortgage payment) is $35,000, the resulting NCF is $25,000 and the yield is 2.5% ($25,000 NCF / $1 million market value).³
There are other potential benefits of investing in real estate that this 2.5% yield doesn’t measure, including property depreciation expense and a possible increase in property market value. Even without taking these factors into account, the 2.5% yield in this example is higher than the current 10-year Treasury yield of 1.5%.⁴
It’s tempting to believe falling interest rates may cause yields and property values to rise. Financing becomes less expensive, so assuming tenants pay the same amount in rent, future cash flows would increase as debt service costs decline.
However, interest rates can’t be considered in isolation. That’s because interest rates are linked to other economic variables that may reduce – or even eliminate – the potentially positive effect of falling interest rates.
In July 2019, the Federal Reserve cut interest rates for the first time in a decade. But not all Federal Reserve Board Members agreed with the small size of the rate cut, or even if rates should have been cut at all.
According to the New York Times, factors the Fed considered when cutting the rate included slowing global growth, the ongoing trade war between the U.S. and China, and persistently low inflation.⁵ The Times also notes that Fed officials were divided when voting to cut the interest rate, citing the strong job market and low unemployment as reasons to keep current interest rates where they were prior to the cut.
According to CBRE, falling interest rates should provide momentum for the commercial real estate industry.⁶
The firm believes that lower hedging costs are expected to support more international capital flows into U.S. property markets. This increased capital flow would, in turn, create some incremental cap rate compression, while lower interest rates help reduce any upward movement of cap rates.
If CBRE’s outlook is correct, then mathematically, property values may increase as cap rates go down or compress, assuming net operating income remains unchanged.
However, similar to the way that Fed Board members were split on whether or not to cut rates, commercial real estate experts are also divided on the effect falling interest rates will have on the real estate market.⁷
As the National Real Estate Investor (NREI) reports, the recent interest rate reduction of 0.25% won’t necessarily stimulate additional investor demand for commercial real estate, in light of the decline in interest rates over the last 10 years. NREI notes that so far, cap rate declines haven’t matched the decrease in Treasury rates. CBRE reports in its First Half 2019 U.S. Cap Rate Survey Snapshot that capitalization rates for all property types in the country changed by less than 0.10% up or down in H1 2019.⁸
Last year, when it looked like the Federal Reserve would be raising interest rates, commercial real estate firm JLL considered the impact changing interest rates would have on investment real estate.⁹ The firm noted that certain commercial property types may be more sensitive to interest rate changes than others.
Investing in property with fixed income characteristics, such as net lease property, may present more risk because leases are typically at longer terms with fixed annual rent increases. On the other hand, investment property with shorter-term leases provides more equity-like characteristics that may perform better when interest rates and the overall economy changes.
Now that the Fed has cut interest rates, JLL recently reported that lower interest rates may boost real estate investor confidence, creating higher investment volumes even at today’s valuations. The firm’s chief economist notes that rate cuts should keep the market attractive to investors in the short run as they search for higher yields and stable returns.¹⁰
When the Fed announced the rate cut in July, Federal Reserve Chairman Powell said the Fed will continue to monitor the country’s economic outlook and act appropriately to sustain the expansion with a strong labor market and an inflation objective of 2%.
There was no indication by Chairman Powell if there will be future interest rate cuts, increases, or if rates will be kept the same. So, it may take some time for investors to decide exactly what the recent rate cut means for commercial real estate.
In the meantime, JPMorgan Chase lists three key takeaways for falling interest rates and their effect on the commercial real estate business:¹¹
Offsetting the economic uncertainty created by the U.S.-China trade war and a weaker global economy
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