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INSIGHTS > FED POLICY AND THE COMMERCIAL REAL ESTATE MARKET: WHAT IS THE REAL EFFECT?

ECONOMIC AND MARKET COMMENTARY

Fed Policy and the Commercial Real Estate Market: What is the Real Effect?

While the Federal Reserve does hold significant power over the U.S. economy, we still operate within a free market.

BY MICHAEL BLOUNT JR   |   SEPTEMBER 2017

SUMMARY

  • Commercial real estate mortgages have not risen as expected in response to increases in the Fed Funds rate.

  • Political unrest, concerns over the domestic economy, and global financial markets continue to dictate bond pricing.

  • As a landlord, expect leasing to be sluggish as potential tenants seek to secure purchasing their own property.

  • Sale prices will continue to be driven upward as interest rates continue to remain low.

Since 2009, the Federal Reserve Funds Rate and Reserve Target have stayed near all-time lows.  The first substantial rate hikes occurred in the end of 2015.  Rates remained essentially unchanged for almost a year before the Federal Reserve began bumping them after the election in 2016.  Over this time period, the Fed's rates have risen nearly 1%, with about 75% of this increase coming in the past 9 months.

Fed Funds Rate.  Courtesy of Bloomberg

As a primer, we need to understand how rates are set.  For the purposes of this article, we will speak in the broad strokes of the bigger picture in the macro market.  The Fed Funds rate affects how expensive it is for banks to borrow money from the Fed.  As it becomes more expensive to borrow, the private banks' loan products must increase in price reflectively (so that the bank remains a profitable spread between the two).  Therefore, as the Fed Funds rate increases, so do the interest rates to the banks' consumers.

 

Second, we must consider the bond market - a parallel, but not completely disconnected financial market.  The federally-backed bonds we are concerned with for the purposes of this article are the 10-year and 30-year maturities.  Historically, a 15-year mortgage is tied to the 10-year bond and the 30-year mortgage is tied to the 30-year bond.  Thus, as a 10-year bond gets more expensive, so does a 15-year mortgage.

THE AUTHOR

Michael Blount Jr

Managing Broker and Analyst

Panoptic [pan-op-tic] -

 

considering all parts or elements; all inclusive.

U.S. 10-Year Bond.  Courtesy of Bloomberg

U.S. 30-Year Bond.  Courtesy of Bloomberg

Typically we would expect to see a waterfall effect that ultimately causes mortgage rates to rise.  By now you are used to the advertisements telling you to purchase or refinance now before the Fed raises rates.  Well, the Fed has done so, but rates have not risen in any appreciable fashion.  In fact, rates have fallen 18 basis points, to 3.77% over the past 3 months according to Bankrate.

 

WHY THE DIVERGENCE?

 

Clearly, the Fed's efforts have not worked - correct?

 

2-year Treasury yield and 2-year real yield 1-year forward.  Courtesy of Bloomberg

In the above chart, the white line is the 2-year treasury yield.  This is compared to the 2-year real yield 1-year forward.  In general, the 1-year forward measure reports the market's best prediction on where rates will be 1 year in advance.  Over the preceding 3 years, the market generally agreed that rates would be the same or that they would increase.  Beginning in Q1 2017, the market began to speculate that yields would fall.

 

In short, markets behave relatively logically on a macro or big-picture perspective.  Initially, there was agreement in the market after the election due to the pro-growth policies of the incoming administration.  The reasons for the divergence in actual versus expected rates are political instability on the domestic front, fear of slowing growth domestically, global instability in financial markets such as China, and finally, geopolitical instability with regard to tensions surrounding North Korea.

 

THE TAKEAWAY

 

While the Fed has been able to strong-arm the market to its will in the past, it has lost much of that power due to a long term easy-money policy and an ever growing balance sheet due to those policies.  The Fed has taken the first step of raising the Fed Funds rates, but the following step of unwinding the monumental balance sheet of assets will be a tricky one.

 

From a real estate perspective, those seeking real property must choose whether to purchase or lease a given asset.  When interest rates are low, parties looking to acquire property are more likely to do so by purchasing the property as opposed to leasing it.  This drives sales prices up and lease prices down.  The opposite is true as rates rise.

 

Landlords should be prepared for sluggish leasing activity, particularly in assets that qualify for SBA loans, as tenants continue to seek purchase opportunities over leasing while interest rates are low.

 

We expect to see a change in the low interest rate environment in the next 6-9 months as political instability continues to slowly wane.  Similarly, a correction in the stock market could cause rates to rise more quickly than expected as investors chase yield.

DISCLOSURES

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular property, strategy or investment. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Past performance is no guarantee of future results.  No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2017, Panoptic Realty Group.

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Panoptic Realty Group is Managed by Michael Blount Jr, a Real Estate Broker Licensed in the State of Texas Under the Texas Real Estate Commission.

 

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