The Fed, Interest Rates And Real Estate

The Federal Reserve increased interest rates in December, but has since held off from instituting additional increases. Its June meeting may see it raising interest rates again.  How do interest rates and real estate interact?

Disappointing job gains in April were an unwelcome sign for the economy, particularly after tepid Q1 economic growth.  Other reports from around the world that suggested weakness in the global economy; a closely watched Chinese manufacturing survey showed production contracted last month, and European Union officials trimmed their forecasts for growth across the 19 countries that use the euro.

Most observers took these developments as signs that the Fed might keep interest rates low for longer than was earlier anticipated. Until recently, Fed fund futures, which are securities that enable traders to bet on which way the Fed will move interest rates, showed that a majority of investors did not expect the Fed to raise rates until February 2017.

Recently, though, the Fed indicated that a rate increase is very much on the table for its June meeting.  The year’s initial equity market fluctuations have seemingly stabilized, and the economy still seems to be expanding at a moderate pace.  It’s thus too early to brush aside the prospect of moderate rate increases during the remainder of 2016.

How will the Fed Act?

The Fed would certainly prefer to have somewhat higher interest rates, if only to have some breathing room so that if the economy runs into a soft patch the Fed can do something to help.  Inflation still seems almost non-existent, though, especially since gas prices have dropped so dramatically.

The most recent jobs report is yet another potential indicator of lingering economic weakness — so the Fed might need to be careful.  In 2011 the European Central Bank twice raised its main interest rate, but it was quickly forced to reverse course and has since cut it even more deeply.

“June is definitely a ‘live’ meeting for the next rate hike, but a super-cautious Yellen might well wait for more convincing evidence of a sustained pickup in the economy and a resolution of Brexit risks before pulling the trigger in July,” said Sal Guatieri, senior economist at BMO Capital Markets.

How Might Real Estate be Affected?

What does this mean for real estate investors?  Aren’t lower rates better for real estate prices, and higher rates worse?

The relationship doesn’t appear to be that simple.   If the economy is doing well and incomes are going up, people can afford to spend more on housing and they’re willing to take a bigger mortgage.  “Intuitively, you’d think that if interest rates go up, [then] house prices go down.  But they don’t,” said Mark Palim, vice president for applied economic and housing research for Fannie Mae.  Values might still go up, even if interest rates increase – although some would argue that increased interest rates will lead to higher expenses, and thus lower net operating incomes (and thus lower rates of return).  In commercial real estate, too, sources such as Morgan Stanley caution that there are a lot of other variables besides just a singular focus on the connection between interest rates and cap rates.  In short, rising rates could affect real estate values positively or negatively;  it depends on investment fundamentals and supply and demand.

The more important relationship seems to be how real estate returns compare to long-term interest rates.  Current 10-yr Treasury Note rates are about 1.75%, and J.P. Morgan estimates that the 10-year Treasury yield could rise to 4.5-5.0% over the next five years.  If the real estate risk premium stays at about 200-300 basis points, then this suggests that core real estate total cap rates could increase to 6.5% and 8.0%.  According to J.P Morgan, today’s pricing might well be sustainableIn J.P. Morgan’s analysis, a 5.0% Treasury world might force some buyers to require a higher relative return– but even a 4.0% 10-yr Note could leave real estate looking attractive on a relative return basis.

All this depends, of course, on exit cap rate assumptions, the effect of interest rates on supply and demand, what’s happening in credit markets, and a myriad of other factors. Most companies doing proper underwriting are careful to model higher exit cap rate assumptions.  Those models generally allow for a bit of “cushion,” and assume that sales will be in a higher interest rate environment.   Whether the cushion is enough will depend upon how the real estate market reacts if rates do indeed rise.  The J.P. Morgan analysis of exit cap rate assumptions in several real estate funds, covering a spectrum of property classes, came to the conclusion that cushions in today’s values may be even wider than the assumption of higher exit cap rates suggest.  But the analysis does not go as far as to say that the market would not be affected by a rise in rates.

The fact that developers appear to be factoring the possibility of a higher interest rate environment should offer some cushion to the market, even if the 10-yr Note begins to climb to more “normal” levels.  But markets have an annoying ability to surprise investors, and if the path to “normalcy” takes an unexpected turn, the impact on risk assets, including real estate, is anybody’s guess.

A version of this article also appeared on LinkedIn Pulse.

Lawrence Fassler
Corporate Counsel
Lawrence has over 15 years' experience as a corporate attorney and has also run a real estate construction business. He previously worked with Realty Mogul, AVE (acquired for over $4 billion), Shearman & Sterling in NYC, and Cooley in their Sand Hill Road office.