Rough Road Ahead?

By Robert Bach, National Director of Market Analytics, Newmark Grubb Knight Frank

Interest rates have bumped up recently, with the 10-year Treasury yield increasing from 1.70 percent on April 30 to 2.16 percent on May 31. This has impacted interest-sensitive assets including REITs, which fell 6.56 percent last month according to the FTSE NAREIT All REIT Index compared with a gain of 2.34 percent for the S&P 500.

This has me thinking about the road ahead as the Federal Reserve eventually reduces and discontinues its bond-buying and begins to raise interest rates. The global financial system has become so accustomed to easy money that the eventual withdrawal of these policies, even gradually, could be rough, especially since so much of the credit markets are securitized and, by definition, subject to volatility.

REITs, being publicly traded, are much more volatile and prone to price swings than property ownership where cap rates can be lumpy and relatively slow to adjust. The availability and pricing of mortgages could be another story as lenders can rapidly change the terms on offer. The “story line” that industry professionals often give (or hide behind) is that the spread between the 10-year Treasury yield and the average cap rate across all property types is about 150 basis points above its long-term average, so there is some room for interest rates to rise without pushing cap rates higher. But when push comes to shove, when interest rates really do begin to go up in earnest, will that be the outcome? Will cap rates sit tight for the first 150 basis points of increase in the 10-year Treasury rate before they begin to rise? My sense is that it won’t be that orderly. Rising interest rates have the potential to dampen risk-taking among commercial real estate and other investors. While prices for trophy assets are likely to be largely unaffected, the frontiers of risk – value-add and opportunistic properties as well as secondary and tertiary markets – could feel some pain, meaning that the recent tightening in cap rates for these riskier properties and markets could stabilize if not reverse.

Whether we’re at the beginning of a sustained increase in interest rates or whether rates will dip back down again is hard to say. There are certainly weak patches in the economy such as manufacturing production that argue for rates to stay low. Yet the housing market is making a surprisingly robust move to the upside, helping homeowners and, by extension, all consumers feel better about their prospects as demonstrated by recent surveys on consumer confidence.

My guess is that we will see interest rates go up and down like a roller coaster in the short-term, but the long-term trajectory will be higher. The commercial real estate industry can take comfort in this, knowing that rising rates signify a stronger economy, leasing activity and market fundamentals. It will give the leasing market a chance to catch up with the capital markets, which have been much further along in their recovery cycle. Falling vacancy rates and rising rental rates will help compensate landlords and investors for higher cap rates when that finally occurs. The Federal Reserve has to return the credit markets to normality sooner or later. Households, businesses and markets will have to make a lot of adjustments along the way. It will be messy. It will be volatile. But through it all the economy should keep growing and commercial real estate should remain an attractive asset class.