Commercial Real Estate, Interest Rates, and the Federal Reserve

On September 20-21st the Federal Open Market Committee will meet and announce their decision on the target Federal Funds Rate and issue guidance on future changes. Given that the unemployment rate has remained stable and below 5% (4.9% as of the latest August report), hiring averaging above 200k per month for the long term, and inflation starting to read above 2% (2.1% annualized rate according to the Price Index of Personal Consumption Expenditures in the second quarter of ’16) it is widely believed that the Fed will resume raising its rate this September if economic conditions remain stable. The current target rate is 0.25-0.50% and any raise in this month is not likely to be more than 0.25%; however, the recent jobs report of only 151,000 (below the hypothetical 200k target to sustain growth) has led some to believe the rate hike will be paused to November.

A quarter point increase in and of itself is not likely to have any real significance to commercial real estate or other long-term assets; what will be impactful is the perceived stance of the Fed going forward with regard to the timing and magnitude of future rate increases. If the Fed postures that it must be aggressive in fighting inflation, then long-term interests will likely rise as could cap rates on investment real estate. This is not a very likely outcome of this FOMC meeting; the more likely outcome is a slight raise, or even deferment to the November meeting, with continued guarded measures to watch conditions unfold. With GDP growth averaging around 1%, it is hard to envision great fears about an “overheated” economy. Thus, it is not logical to expect much to change in the near term for commercial real estate, whatever the Fed may decide.

The Federal Reserve: Promoting Full Employment and Price Stability

To understand what the Fed is attempting to do, one must remember that they are said to operate on a “dual mandate” to promote full employment and price stability (i.e., keep inflation in check). At 4.9%, the US economy is theoretically at “full employment”, but given the slow rate of wage growth, small gains in productivity, and seemingly tenuous inconsistencies in hiring (May added only 24k new jobs) there is not a widely held view that the employment situation is healthy enough to sustain new economic shocks. Further, the unemployment rate that includes discouraged, marginally attached, and part-time workers who would prefer full-time employment stands at 9.7% (this is known as the U6 measure) which is above its hypothetical target of around 8% but drastically improved from its recessionary peak of 17.1% in December of ’09. Thus, the Fed has little motivation to “pump the breaks” and risk moving away from full employment.

Inflation and price stability is much trickier to assess. The Bureau of Economic Analysis produces the Price Index of Personal Consumption; as stated above its most recent reading is above 2%. The more commonly cited Census Bureau Consumer Price Index (CPI) is currently reading 0.8% annualized for all-items and 2.2% for all-items excluding food and energy. Overall, prices do not appear to be rising in totality, but certain areas such as Shelter, Transportation Services, and Medical Care are all growing at rates above 3%. If energy prices were to move upward, overall inflation could spike well above 3%. Thus, the Fed is pressured to “not wait too long”.

Impact on Commercial Real Estate

Commercial real estate has been in the winner’s circle for quite a few years, benefiting from high rent growth and simultaneously low interest rates and capital costs. Even low energy prices have a direct boost to net operating incomes of many commercial landlords. This dynamic is not poised to reverse itself in the short or even medium term. In fact, as fixed-income securities are much more at risk to interest rate spikes, more investment capital could move to CRE assets as a result of the Fed decision. In summation, real estate investors have little to worry about this round; but, it would be foolish to believe this low interest rate, high rent growth environment will last forever.

To learn more about the current CRE market and economic conditions throughout the U.S., read the 2016 Market Outlook Reports here.

[bctt tweet=”Real estate investors have little to worry about this round #CRE” username=”svnic”]

2016 Continues to be a Year of Strong Performance in Commercial Real Estate

While macro-economic uncertainty and global instability may grab headlines, commercial real estate fundamentals and pricing continues to grow and expand according to second quarter results of major real estate data providers REIS, Inc. and CoStar Group. Overall with limited exceptions, all major sectors of commercial real estate experienced positive net absorption, declining vacancies, and positive rent growth in the second quarter of 2016, continuing a growth trend that has been in place for several years now according to REIS, Inc. The leading sector, in terms of rent growth, was multifamily with an approximate 1% growth in effective rents while office, industrial, and retail all experienced rates around 0.5%, which is just above estimated inflation. The improvements come as a result of sustained, stable new demand and limited new supply. In fact, REIS, Inc. reports that in the second quarter, completions of new apartment units, office space, and retail space fell in year over year measures as the overall pace of new construction slowed slightly. Census Bureau data also showed an overall rate of decline in volume for construction spending in all categories as well.

Slow and Steady Growth Through 2Q ’16

Thus, the markets are facing a continued dynamic of slow, but meaningful demand growth with relatively slower rates of new supply expansion; thus the result of higher rents and lower vacancies is entirely logical. Further, this condition of relative undersupply is only likely to get worse before getting better as capital markets remain constrained in financing new developments. So for now, tenants will be the losers and landlords the winners. Of course, the lack of quality, available vacant space in some markets is actually forcing firms to move markets to expand and thus causing some pain in some municipalities’ economic development initiates. Enterprising developers in certain markets may find great reward in speculative development at this stage of the cycle.

Pricing of commercial real estate assets also showed growth in the second quarter of 2016. CoStar Group reported a quarterly gain in pricing of 2% which represents a reversal from the first quarter which saw modest declines. CoStar’s value-weighted US Composite Index, which is more representative of large institutional grade assets, was up 3.3% quarter over quarter; while the equal-weighted US Composite Index, more inclusive of smaller properties, rose by only 2.1% in the second quarter. All property types were positive with apartments being the year over year leader at 8.5%. While all pricing results were positive, the rate of growth for 2016 is slower than 2015, but still pointing to the potential for 2016 to be a record-setting year.

Supply, Demand, and the Strengthening Job Market

The most recent quarterly results highlight the fact that supply and demand fundamentals are driving the commercial real estate markets despite turbulence in the capital markets, tightness in the lending environment, and even macro-economic slowdowns. Thus, it is logical to expect most markets to show resilience in the face of continued uncertainty. Of course, national job growth, which showed the initial signs of a slowdown, has rebounded back to strong positive growth in the past two months which is a positive indicator of real estate demand increasing in the near future. Overall, investors should be most concerned with monitoring localized oversupply or idiosyncratic demand pullbacks as the nation appears very stable and relatively healthy.

The next shoe to drop could be the Federal Reserve resuming their planned interest rate hikes given the positive hiring results of June and July. This could of course impact commercial real estate by raising cap rates and increasing the index rates of new loans. Since today’s cap rate spreads to treasury rates remain relatively wide, there need not be significant impact from such events but are nonetheless a source of risk, especially to pricing.

To learn more about the current CRE market and economic conditions throughout the US, read the 2016 Market Outlook Reports here.

Tag: Economic Update

September 2016 Commercial Real Estate Update