The Federal Reserve’s decision to suspend rate hikes this year and end the runoff of its balance sheet was closely watched across the commercial real estate sector for good reason. These moves coincide with a period of significant financial market volatility, and choppy economic waters.
The host of factors weighing heavy on commercial real estate decision-makers range from trade wars between the U.S. and China, interest rate increases and potential decreases that’s complicating matters, as well as a jittery global economy that appears to be losing steam. It is making it more difficult to chart a savvy investment strategy for those in the commercial real estate industry.
Glenn Gioseffi, Kidder Mathews’ Senior Vice President, Debt & Equity Finance in Seattle, weighed in on the expected impact of interest rates for CRE investors or owners. He says, “If interest rates do rise in the future as suggested, the following is expected. When interest rates rise, cap rates rise, and values fall. Assuming NOI is the same.”
But, there is another consideration that CRE investors must keenly watch. The overall uncertainty comes at a time when there’s been robust demand for Treasuries. In turn, that’s pushed the 10-year Treasury below the 2.5% range, and ushered in a condition economists refer to as an inverted yield curve. Many observers believe an economic downturn and rate-cutting can’t be too far off.
Gioseffi points out the yield curve inversion has implications for the CRE sector, too. “Inversions signal inflation in the next 12 to18 months,” he says. “Inflation means higher prices and more money going to expenses, hence lowering the NOI and property value. Inflation also means higher rates, as noted earlier.”
What has happened is the gap between three-month yield and 10-year yield disappeared recently, as short-term debt was paying more than long-term debt. This is the first time since the Great Recession that the yield curve for Treasuries has inverted. A surge of buying drove yield on the 10-year Treasury down from more than 3.20% late last year. The three-month yield was 0.03 percentage points higher than the 10-year yield. This flip is largely considered by economists as a reliable predictor of past recessionary times in the U.S. Many sense a downturn could ensue in the coming 12 to 18 months. It is worth noting that the 10-year yield still remained above the two-year yield of 2.31%.
The rise in demand for the safety of government bonds followed the Fed’s decision to hold interest rates steady in March, amidst lowered growth projections. Traders viewed those events as a sign that money policymakers expect a cycle of easing. And, it is likely the bond market priced into the mix a cut by the end of 2020 and a decent chance of a reduction this year.
The Federal Reserve also recalibrated its 2019 GDP growth projections for the year lower than prior forecasts. Instead of two planned increases in the Fed Funds rate, the Fed is indicating that no additional increases would occur in 2019. That change of direction has many market observers believing rate cuts can’t be too far off.
Gioseffi says capital is still flowing into commercial real estate, despite the changes in economic conditions and monetary policy. “Investors are still interested in CRE, though they are pursuing more apartments, and less retail,” says Gioseffi. “Money is going into bonds as yield rise.”
The implications for those in the real estate sector means a few asset classes are falling out of favor, while others are ones that should be closely watched. Gioseffi says, “retail is most affected. Though industrial could be hit hard if you are an exporter of goods.”
Gioseffi advised adopting a strategy of “buying with long-term fixed debt,” in order to prepare for what may be next.