What Those Rate Hikes Really Mean For CRE

The recent rate hike by the Fed will “ultimately benefit” commercial real estate on a long-term basis, according to a pair of industry experts. 

“The fundamental intent is to reduce the risk that elevated inflation will become entrenched, forcing the Fed to hike rates more aggressively in the future and potentially sparking a recession, which would clearly be a worst outcome for many sectors including property,” Cushman & Wakefield economists Rebecca Rockey and James Bohnaker write in a new analysis. “The gradual move now by the Fed is a necessary step to help achieve the second part of its dual mandate: achieving price stability, a precondition for a sustainable healthy labor market. Ultimately the confluence of these two objectives being achieved will help to sustain the CRE expansion.”

Real GDP is predicted to grow around 3% in 2022, a rate Rockey and Bohnaker say is “well above” historic norms and the overall economy’s long-term potential growth rate. They say that will generate demand for all property types, translating into improving fundamentals across most markets and assets. 

What’s more, profit margins are at historic highs economy-wide, providing more breathing room to absorb higher costs of capital. 

Analysts across the industry have been weighing heavily over the past few weeks on whether commercial real estate will continue to be an effective hedge against inflation. Generally speaking, they tend to agree for that to be true, investment times should be longer. 

But Rockey and Bohanker also posit that interest rates are still quite low and are likely lower now than they will be in a year or two. 

“Floating rate debt is going to become more expensive: locking in still attractive longer-term fixed rates is a strategy to consider,” they say. But “the financial market knew this was coming and had already priced in seven rate hikes this year. The 10-year Treasury yield has already captured these expected rate movements, which is partly why it has drifted up in recent weeks. Chair Powell even alluded to that while monetary policy acts with a lag, recent movements in the market have essentially helped the Fed and began some of the tightening effects sooner. This is what Fed credibility looks like.” 

Citing Fed Chair Powell, the pair put the odds of a recession in 2022 as “quite low”—less than a 10% probability. 

“Play the odds,” they say. “Historically, liftoff has been followed by periods of economic growth. On average, from the start of rate increases to peak, real GDP has grown by 15.3%. Growth is even higher when measured from the start of rate increases to the start of a downturn—real GDP has averaged a 19.2% increase (peak rates do not always coincide with the end of an expansion).” 

They also note that there is “essentially no correlation” between changes in the federal funds rate or the 10-year Treasury rate and property cap rates—but note that “the narrower spreads are when rates change, the more likely cap rates are to rise.” 

“Said differently, the context of changes in interest rates is critical,” they conclude. “Recently, risk aversion has been rising in tandem with interest rates as reflected in widening spreads in corporate bond markets and declining price-to-earnings ratios in global equity markets. CRE debt and equity pricing are likely to come under pressure with this being felt unevenly across sectors and geographies depending on the willingness of investors to accept smaller risk premia.”