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HFF Research Update for Q3 2015: How Commercial Real Estate Might Respond to a Rise in the Fed Funds Rate

Tuesday, November 03, 2015

Quarterly insights on current research in the commercial real estate industry from HFF Managing Director of Research Jimmy Hinton.

In some manner, the current economic recovery resembles prior history, but in many ways, it is outperforming handsomely. This has led to increasing probability the Federal Open Market Committee (FOMC) will increase its “Fed Funds Rate” in the coming months. In fact, the FOMC has so often hinted at a move that many believe a hike is assured, but it is merely a question of timing.

Still, there are others who are convinced global conjecture relating to the trajectory of economies across the globe will prevent any FOMC tightening. The impact such a move could impose on investment markets is an interesting and highly-debatable consideration. More specific to HFF and its clients, the impact of a rising Fed Funds Rate on commercial real estate liquidity, as measured by transaction volumes and capitalization rates, is more relevant. Hereafter, we make a cursory attempt to provide some context to both.

Recent Economic Performance

For some time now, U.S. payrolls (orange line below) have experienced expansion in an arc closely resembling 2003 to 2007. Specifically, monthly payroll additions (dark blue bars below) have been positive for 60 consecutive months, the longest streak since a 46-month period of expansion ending in June 2007. The average monthly addition of jobs (light blue line below) over the past 60 months has been ~201,000, which is very attractive not only in itself but especially when compared to the run-rate of ~171,000 in that 46 month period ending June 2007. During that 46 month period, the FOMC increased its Fed Funds Rate on 17 separate occasions, each time by 25 basis points (that’s 4.25 percent in total) as it sought to fight off inflating valuations of single-family homes, stock market indices and other investments. What impact did these moves have on interest rates and commercial real estate transaction volumes?

Economic Rates Memo 

Interest Rate Response

The graph below demonstrates the movement in the effective yield on the ten-year United States Treasury (orange line) in periods of Federal Reserve monetary policy actions. The green shading reflects periods wherein the FOMC cut its target interest rate (accommodative policy); the red shading represents periods of increasing target interest rates (tightening policy). As explained earlier, during the nation’s last enduring economic recovery from September 2003 to June 2007, the FOMC made 17 individual increases to its Fed Funds Rate amounting to an aggregate increase of 425 basis points. Meanwhile, the effective yield on the 10-year UST increased by a relatively modest ~110 basis points. In short, consistent and significant increases in the Fed Funds Rate did not result in a 1:1 increase in prevailing Treasury yields, though directionally the moves were similar over time.

Interest Rate Response 

Commercial Real Estate Industry Response

The graph below reflects quarterly commercial real estate transaction volumes (blue bars) and industry-wide capitalization rates (yellow line). During the most recent period of a rising Fed Funds Rate, commercial real estate transaction volumes rose steadily, reflecting improving operating fundamentals and increasing interest in the asset class. Ad interim, capitalization rates declined in spite of the rising benchmark yield of the 10-year UST, compressing the risk premium investors required to invest in commercial real estate assets. The conclusion here, again, is that a rising Fed Funds Rate does not guarantee a decline in liquidity and/or an increase in discount rates. Such phenomenon, in fact, has proven more likely in an environment of a declining Fed Funds Rate, when investors might be seeking surety in favor of risk.

CRE Rates Memo 

A closer inspection of capitalization rates’ response to the Fed Funds Rate is warranted. As previously reported, the yield on the 10-year UST rose ~110 basis points from September 2003 to June 2007. Meanwhile, capitalization rates on commercial real estate transactions fell ~150 basis points. Combined, investors’ appetite for the asset class resulted in a ~250 basis point decrease in the risk premium required above the 10-year UST, falling as low as 1.44 percent.

CRE Response 

Current Cycle Similarity to Long Term History

How does the commercial real estate industry’s response to the most recent hikes in the Fed Funds Rate portend future performance? It is important, first, to establish a baseline prior to any future rate hike. The yield on the 10-year UST has risen ~29 basis points from 1.88 percent in the fourth quarter of 2011 to a an average yield of 2.17 percent in the third quarter of 2015. Meanwhile, capitalization rates have continued to compress by ~47 basis points reducing risk spreads to just over 410 basis points. To be sure, investors have compressed the risk premium they require by ~76 basis points but the current spread is still handsomely wide of long term averages.

Cureent Cycle Similarity to Long Term

 Since 2001, the average spread between capitalization rates and the 10-year UST is 367 basis points, effectively ~45 basis points narrower than current metrics. I often believe the long-term average isn’t a terribly reliable benchmark. After all, it includes periods of euphoria (2007) and periods of hysteria (2009). One should endeavor, therefore, to compare current pricing to the most “relevant” era, which we believe to be late 2004 to early 2007.

Current Cycle vs. Relevant History

Why is that time period more relevant? Look at growth in transactions volumes in that time period relative to what has taken place more recently. The last two quarters notwithstanding, the similarities are striking, with the two sets of transaction volumes enjoying a positive correlation.

Current Cycle vs. Relevant History 

In addition to transaction volumes, it is also relevant to analyze pricing metric changes in these time frames, as they prove divergent. In the eleven quarters spanning the fourth quarter of 2004 and second quarter of 2007, cap rate spreads to Treasury fell ~155 basis points to 1.44 percent. By comparison, in the 11 quarters spanning the first quarter of 2013 and third quarter of 2015, cap rate spreads to Treasury fell ~77 basis points to 4.12 percent. While transaction volumes in these two time frames have proven very similar, the ability of investors to maintain outsized cap rate spreads in the current cycle has allowed CRE the designation of a favored asset class among investors.

Current Cycle vs. Relevant History Continued 

Q3 2015 Conclusion

The average spread between capitalization rates and the 10-year UST from 4Q 2004 to 2Q 2007 – what we have just established as a very relevant time period to compare to current market conditions – was 219 basis points, compared to an average spread of 413 basis points over the more recent past and a current spread of 412 basis points. From a longer term perspective, since 2001 the average capitalization rate spread to the 10-year UST is 367 basis points. Some market participants argue the 10-year UST has little room to compress further and therefore is less likely to do so in an environment of rising target interest rates, as it did in the previous cycle. They also argue that in light of the current spread between capitalization rates and the 10-year UST being only 45 basis points above the long term average, that capitalization rates, too, must rise. In our view, the market is entering a period of tightening monetary policy with a healthy risk premium to the risk free rate.

Given the nation’s impressive economic expansion, the lack of meaningful new supply underway nationwide, rising capital allocations to commercial real estate globally and the unlikelihood of increases to the Fed Funds Rate in excess of 25 basis points at a time, we do not believe there is a significant probability capitalization rates will rise when the FOMC tightens monetary policy later this year. That being said, low yielding, highly levered and/or fixed-income fashioned properties will, of course, be the most sensitive to any forward increase in capitalization rates. Owners of such assets should consider the net operating income growth necessary to hold asset value constant in a rising rate environment.


About Jimmy Hinton

Mr. Hinton serves as Managing Director of HFF, responsible for the firm’s research efforts. Mr. Hinton works with the HFF Jimmy Hintonexecutive management team to assist in investor relations and to inform both HFF staff and firm clients with in-depth analysis of economic, property and capital market trends. He is also responsible for providing extensive market reports, client presentations and deal-specific analysis for debt placement and investment sales assignments. Mr. Hinton’s responsibilities include substantial interaction with pension funds, life insurance companies, regional and CMBS lenders, REITs, foreign investors and private equity funds.

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