Fed Rate Cut Strengthens Yield for Commercial Investors
On September 18, the U.S. Federal Reserve announced that it will lower federal funds rate by 25 basis points to a range of 1.75% to 2.00%, as the continued trade war between the U.S. and China, sluggish global growth, and muted inflation clouds the economic outlook. The Fed wrote in a statement, “Although household spending has been rising at a strong pace, business fixed investment and exports have weakened” and “uncertainties about this outlook remain” as factors in its decision to lower the benchmark federal funds rate. The 10-year Treasury rate decreased to 1.80% on the news, down 22 basis points since the Fed announced its last rate cut on July 31, its first rate cut in more than a decade.
What does a lower federal funds rate rate mean for commercial real estate investors?
At the beginning of the year, many economists and investors anticipated long-term rates would be in the 3% range and rising—potentially putting pressure on property values and decreasing demand for debt. Instead, the 10-year Treasury yield decreased and many market participants are planning for rates to remain ‘lower for longer’. The result would typically lead to heightened demand and higher sales volumes for commercial real estate investments, resulting in continued cap rate compression if the yield premium remains constant. However, the increased risk of a recession has caused investors to seek an increased premium in order to acquire real estate assets. This similar dynamic was illustrated during the Great Recession when the Treasury rate and cap rates went in opposite directions.
As of mid-September 2019, the average commercial real estate cap rate ranged from 5.8% for multifamily to 6.7% for office and industrial and 7.1% for retail properties. Compared to the 10-year Treasury rate of 1.80%, spreads over cap rates and interest rates range between 400 basis points in multifamily investments up to 530 basis points in retail investments. Over the past few years, the low interest rate environment has pushed property values higher and increased demand for debt capital as the economic continued its historic run. This can be illustrated in the forecast from the Mortgage Bankers Association (MBA) released stating that commercial mortgage bankers are expected to close a record $652 billion of loans backed by income-producing properties in 2019, which would be 14% higher than last year’s record volume of $574 billion. However with treasury rates causing the yield curve to flatten, and momentarily invert, the signs of a recession may lead real estate investors to be more conservative in their acquisitions and banks to tighten up credit going forward, which can decrease the demand for investments in real estate and result in an increasing cap rate environment.