The Fed Hike
In December 2015, the Fed raised interest rates by 0.25%. The historical hike marks the first time the Fed has raised rates in nine years. It’s an increase with complicated effects. And those effects mean different things to different people.
What does this potentially mean for commercial real estate (CRE) investors? Read on to find out.
Increased Borrowing Rates
It won’t happen in the blink of an eye, but in time, the Fed’s interest rate increase will raise borrowing rates.
Historically, CRE borrowing was priced off a bank’s prime rate. As CRE became institutionalized, loan pricing became more dynamic and included options for 5-, 10- and 20-year treasuries and CRE bridge loans tied to the London Interbank Offered Rate (LIBOR). Now, borrowers can secure capital from nontraditional investors including hedge funds, private equity debt funds and crowdfunding.
All traditional and nontraditional loan variations are tied to the Fed’s actions, and all will likely see a marginal increase in rates. Treasuries and LIBOR rates will be tied more closely to the Fed’s increase. Nontraditional lenders have more flexibility, and may be less reactive to the increase than their financial institution counterparts.
“Clearly, interest rates are very important to real estate prices, and the reality of a rising interest rate environment will be headwind for the market in 2016 and beyond,” says Real Capital Analytics in a recent report.
Despite the increase, CRE could remain a potentially attractive risk-adjusted investment alternative. Borrowing costs are still historically low. The Fed’s move to increase and normalize rates is a measure to provide future stability. This, coupled with lessons learned during the Great Recession, will likely spell a positive future for CRE.
Restricted Borrowing Opportunities
With the rise of interest rates, financial institutions may restrict lending opportunities to minimize losses.
“The extra yield buyers demand to own commercial mortgage bonds relative to benchmark interest rates has surged to the highest since 2011, meaning investors view the securities as increasingly risky,” Sarah Mulholland reported in Bloomberg Business. “Since January, the spread between the benchmark and CMBS rated BBBminus, the lowest investmentgrade ranking, has jumped 240 basis points, or 2.4 percentage points.”
The higher the interest rate, the more incentive there is to minimize risk for lenders and borrowers alike. Higher interest rates give both parties a reason to be more cautious and thoughtful. Lenders want to ensure property values stay stable. Borrowers want to be certain they will be able to maintain cash flow.
Bumpy Stock Markets
Stock prices move relative to a lot of factors, including interest rate increases.
The first Fed hike was priced, anticipated and delivered in December. The increases to follow are expected to be relatively small and should be quickly priced into the market. However, the Fed isn’t giving the market a clear picture of when the next increase will come and how many will follow, creating uncertainty in both the stock and bond markets.
Like any investment, real estate carries risk and does not guarantee returns or preservation of capital. But CRE can potentially be a good alternative in volatile stock markets. Its fundamentals—rent, occupancy and cap rates—all continue to improve. The predictable cash flow, transparent markets, potential downside risk protection and relative liquidity are reasons why some investors choose CRE.
The real impact of the Fed’s increase in rates will happen slowly, over time and with incremental rises in basis points. But for better or worse, it’s happening. Knowing the details helps investors better understand the potential impact on your real estate investments.