What happens to commercial real estate when interest rates jump up? It’s a trick question — the industry just spent the last two years finding out. Now the Federal Reserve’s Federal Open Market Committee is under a microscope as everyone in CRE scrutinizes every action and statement out of the Fed. So, what will happen?
A Trepp analysis points out with the most obvious, that cuts to the federal funds rate — the range at which banks offer unsecured overnight loans to one another — could possibly pump life back into CRE transaction volumes. But it will take time.
To get an idea of how some factors interplayed in the past, Trepp looked at interest rate cuts after periods of elevated interest rates and compared them to rates of increased transaction volumes, property valuations, and loan originations. They did note that correlations aren’t causations.
After the Global Financial Crisis (GFC), the Fed dramatically cut the federal funds rate. At the time, credit took a beating and liquidity was extremely low. As more liquidity became available, there was an increase in commercial real estate debt and equity investment.
A similar pattern could play out today, with rates coming down from high levels over the last two years, though with a far smaller immediate impact.
Even though the federal funds rate is down by 75 basis points so far, property owners and investors might not see lower rates for some time. Changes need to percolate up, and the cumulative amount of cuts so far isn’t large enough to be compelling for many, as multiple sources over time have told GlobeSt.com.
The Fed could signal further rate cuts to generate a wave of activity over the next few quarters, although that doesn’t seem likely. The central bank has been adamant that it was watching the data and would speed or slow rate changes depending on where conditions moved.
Another potential source of slowing is that CRE is a leveraged asset class. An increased cost of capital slows transactions because the bid-ask gap widens during a price discovery phase and cap rates adjust more slowly.
One place lower rates might become evident is in refinancing. Borrowers who opted for floating rates — without sufficient hedging strategies, to round out the picture — saw the costs climb. The 75-basis-point fall is low in comparison. If rates fall sufficiently, those borrowers might refinance into something more stable and predictable. They also might be able to sell at a higher price than they would otherwise get as the financing becomes more affordable for the buyer. However, many would-be sellers and buyers will likely wait to see if rates fall further.
Interest rate cuts typically increase transaction volume “once transactional cap rates exceed borrowing costs.” Sufficient time must pass — a year or two isn’t uncommon — for markets to adjust to the new rates.
Property valuations also rise after rates fall. The change enables more potential buyers to consider a given investment, increasing competitive demand and property prices, so long as buyers can find a way to their desired returns on investments. Not all sectors may feel the same lift. Lodging and retail are dependent on wider economic conditions and consumer confidence. Office is still under the thumb of changes in where work is done. Again, another source of potential delay.
Similarly, there is generally a delay between rate cuts and volume of loan origination. “Historically, it can take up to 18 months for lower rates to fully translate into higher origination volumes,” Trepp wrote. “This delay occurs as both lenders and borrowers adjust to the new environment and renegotiate loan terms.”
In short, lower rates will help CRE in time and not evenly across all property types.
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