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Cap Rates Vs Fed Funds

January 19, 2020

With the recent rate hikes coming from the Fed, real estate investors are wondering which way capitalization rates (net operating income divided by property value) will move. An oversimplified view is to recognize the relationship between the higher cost of borrowing and its impact on the profitability of income producing real estate. However, cap rates vary based on more than just interest rates, namely inflation (real estate as a hedge against inflation), economic growth, jobs, demand, and the risk appetite of buyers – which is impacted by a variety of factors, some of which are personal/individual and thus impossible to know or analyze.

Real estate values will not be hurt by rising rates if the rate hikes come due to real economic growth.

While the world is quite certain that rates are going to move higher, it unclear just how high. Since the inception of the central bank, economists have shared a common consensus that 4% is a healthy long run target rate (currently the fed funds rate is 1.50%). However, Janet Yellen argued,and some would say proved,that our economy is fundamentally different than in years past. Specifically, our GDP growth has been much more tepid in this most recent economic expansion due to many reasons including technology’s impacton the job market. Because of this significantly lower GDP growth rate as well as stubbornly low inflation, Janet Yellen fought hard to convince others that the new target Fed rate should only be 2%. This is a 50% reduction from the past target rate of 4% and is a shock tomany people who have lived a lot longer than I have and have experienced the days of 15%+ rates in the early 1980s. New Fed chair Jerome Powell, has never openly disagreed with Yellen, who strongly pushed to keep rates extremely low in the face of harsh critics claiming she would bring on detrimentally high levels of inflation. However, she successfully ushered our economy into a strong expansion period from 2008 to present. In spite of near zero rates for much of the last decade, inflation has surprisingly remained below the Fed’s target of 2%. Even in the face of record low fed rates and massive quantitative easing, inflation barely budged during this period. We are now finally starting to see inflation move higher and it is the Fed’s job to ascertain whether or not this inflation is due to positive economic fundamentals such as robust wage growth and an increase in consumer spending. If this is the case, then the Fed will be empowered to continue to raise rates. However, the Fed has proven to be extremely dovish and shown confidence in their ability to avoid inflation even at these extremely low interest rate levels. Many are concerned that if the Fed doesn’t raise rates fast enough then fiscal stimulus won’t be available when the next contraction plagues the economy. However, the Fed feels confident in their ability to stimulate the economy even in a zero bound rate environment. “In his now (in)famous 2002 speech Bernanke outlines the entire Fed playbook for combating deflation at the zero-bound rates. This includes existing and soon-to-exist experimental strategies such as direct purchases of private securities and foreign government debt, low-interest loans to banks, government debt purchases, time commitments to hold rates at zero, forced caps on yields, and intervening directly to affect the foreign exchange value of the dollar.“ (Volatility at World’s End: Deflation, Hyperinflation and the Alchemy of Risk 8). This should allay fears that the Fed is looking to drastically raise rates. Looking past fiscal policy, commercial real estate prices are typically quite resilient in the face of higher rates due to a variety factors including: geopolitical risks, foreign capital inflows, and future inflation. Geopolitical risks and negative interest rates around the world have been forcing foreign investors to bring their money to America in search of yield producing assets. More capital chasing after this limited number of assets naturally increases prices and lowers returns for real estate investors. Real estate is commonly referred to as a great hedge against inflation. Our economy hasn’t seen real inflation in over a decade and will certainly benefit froma mild dose of it.

The recent rise in US treasury yields and the stock market correction should lower investors’ risk appetite and push capital towards bonds. However, investors fearful of inflation are running away from bonds and into inflation hedges such as real estate.

In conclusion, Cap rates should move a bithigher (lowering the value of real estate) in a rising interest rate environment. However, the Fed has stated they only want to raise rates due to substantive inflation (real economic and job growth). These factors are positive for occupancy rates and rent growth which would make up for higher cap rates and buoy real estate prices. The market is factoring in two or three 25 basis point rate hikes over the next year or so and these hikes are already priced into the bond yield curve. After the recent stock market correction and resulting capital flows to the bond market, the Fed is less inclined to raise rates much further.