|The Fed's Increase in Interest Rates and Its Impact on Commercial Real Estate
- As expected, the Fed raised the Fed Funds rate by 25 bps today
- Market mostly priced in this result, so near-term volatility is muted
- Additional moves likely, but will come slowly and some markets will be more resilient than others
- Global factors including China and oil prices could slow path of rate rise
The Federal Open Market Committee (FOMC) raised interest rates today for the first time since 2006. The 25 basis point increase to the target federal funds rate was all but a forgone conclusion for anyone following financial news in the last few weeks. Wall Street was hardly caught off guard; interest rate futures placed a better than 75% probability of this result since the release of the strong October jobs report. The strong November jobs report, in particular the first evidence of wage inflation (the other "I" word) in some time, sealed it.
We do not believe today’s move will have any impact on the commercial real estate markets and that the Fed likely has significantly more room to move before we begin to see real pressure on cap rates. That said, certain markets may be more susceptible than others to interest rate increases as noted in our piece from early September: Identifying market risk for cap rate increase under Fed tightening. Our estimate of markets that may be more affected than others include the following:
The flow of international funds—combined with domestic pension funds' large pools of capital allocated to commercial real estate but unspent—will outweigh any potential increase in the cost of capital. The wildcards here include the price of oil, an economic hard landing in China, which would lead to pull back in Chinese capital flows, or some other "black swan" event which would impair global growth. But even this type of event could easily cause the Fed to reverse course, neutralizing any potential capital outflows.
Some characterized today's move with phrases such as "pulling the trigger" or "liftoff," but the reality is much less explosive. The initial rate hike is just another baby step in a long haul toward conventional monetary policy. While we expect these baby steps of 25 bps incremental increase to continue through the next year, the Fed will only do so in a U.S. economy that continues to improve and a world or black swan event that doesn’t throw a monkey wrench into the path of the tip-toeing baby. The beauty of Janet Yellen's data-dependent credo is that it allows the Fed to adapt to ebbs and flows in the economy. You will almost certainly not see a repeat of the last tightening cycle in which the Fed raised rates at 17 consecutive meetings.
Despite the big news of today's move, the Fed has stealthily been in tightening mode since ending its asset purchases in October 2014. A shift toward more hawkish communication has altered the public discourse to focus on the mechanics, timing and pace of interest rate increases. The Fed's consistent communication about future policy—referred to by Ben Bernanke in his recent book Courage to Act as "Open Mouth Operations"—is a de facto rate hike in itself and dampens the real impact of today’s announcement.
Reading the tea leaves of the next Fed move is more complex than ever now that financial market health and global growth play a more prominent role. The U.S. may still be the biggest kid in the school yard, but it has a lot of other major global players to deal with and the Fed is more sensitive to global activities than ever. Not the least of these worries is the health of China followed by the health of emerging markets that have borrowed heavily in US dollars and may not face additional stress if the US dollar strengthens further.
The bottom line is that the Fed is raising rates because the domestic economy is doing well. Things may get tricky as the expansionary cycle runs its course and interest rates near equilibrium, but that’s still a few years away. So for now, sit back and watch the data.