How a Rate Hike could Impact Commercial Real Estate

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The Federal Reserve is hinting again at a potential rate hike in September.

Recent data has made policymakers a bit more confident that inflation is nearing a healthy target of 2%; that unemployment is improving; and that global headwinds are beginning to cool. While there are still a great number of economic concerns, including a GDP rate of 1.1%, the Fed is ready to push ahead with hikes anyway.

According to the CME Group, there are 73% odds that we’ll see a hike in September. And, according to Mohamed El-Erian, chief economic advisor at Allianz, odds could rise as much as 80% if the latest jobs report shows improvement.

If we see more than 180,000 jobs with increasing wage growth and higher inflation, the Fed is likely to move. But it may just be one of the worst moves it could make just months ahead of the November elections. Crashing the market with an ill-time hike could be devastating to markets, just as it was after the December 2015 hike.

If we look at changes in the Federal Funds rate dating back to 1990, the central bank has never raised rates in the two months leading up to an election.

Raising rates too soon could again rattle stock markets. It could also damage consumer and business confidence, and have a negative impact on the elections.

Also, the economy is not strong enough for a hike.

Unemployment is nearly 10%, per the U6 with more than 93 million Americans out of the workforce. If unemployment were truly near full employment, inflation would be near the Fed’s healthy target of 2%. It’s not.

Instead, the Fed’s preferred measure for inflation – core PCE – has been stuck around 1.6% since March 2016. That’s in addition to slowing labor productivity, and falling business investments. In short, the U.S. economy is not ready for a rate hike.

Another wrong move by the central bank could easily disrupt a very fragile economy and send U.S. markets much lower.

So, what does a potential rate hike mean for commercial real estate investors?

While real estate investors fear rising rates could damage property values and weakened returns, the fears are unfounded.

Here are some reasons why, as we also noted in May 2016.

No. 1 – Fears of Higher Borrowing Costs are overblown

Higher borrowing costs won’t happen overnight. But over time, as interest rates move aggressively higher, borrowing costs may rise. However, this is not a great concern at the moment, as such costs are still historically low.

In fact, according to an Ernst & Young report, “there has been significant growth in the availability of capital from nontraditional lenders, including hedge funds, business development companies, sovereign wealth funds, private equity debt funds, life insurance companies and mortgage REITs, as well as a host of opportunistic mezzanine lenders. This is, in part, due to a recoiling from massive losses incurred by traditional financial institutions during the financial crisis, greater regulatory oversight and increased demand for capital to fund investments in an asset class that is becoming increasingly institutionalized on a global stage.”

No. 2 – Real Estate is Still a Safer Investment

With the fear of interest rate hikes rattling markets, investors have become fearful, creating incessant volatility in stocks and bonds. That may spill over into real estate, as well. However, while real estate does carry risk, it is still a better alternative to stocks and bonds. Predictable cash flow, market transparency, and lower risk make real estate a safer investment.

No. 3 – Foreign Interest in U.S. Property could double

Chinese investors have been pushing into higher yielding opportunities abroad, especially in real estate. In fact, according to a new report from the Asia Society and Rosen Consulting Group, Chinese investors have become the largest foreign buyers of US property after pouring billions into the market in search of safer offshore assets.

After a substantial surge in residential and commercial real estate from Chinese investors in 2015, the five-year investment total has ballooned to $110 billion. “The sheer size of that total has helped the real estate market recover from the crash that began in 2006 and precipitated the 2008 economic crisis,” says the report. And, despite a recent clampdown on capital outflows, that $110 billion figure is expected to double this decade hop over to these guys.

Between 2010 and 2015, Chinese investors bought more than $17 billion of U.S. commercial real estate, with half of that spent in 2015 alone. Another $93 billion was spent on U.S. homes across some of the most expensive markets, including New York, Los Angeles, Seattle, and San Francisco.

Better yet, the buying spree isn’t expected to slow. Long-term economic drivers are expected to remain quite strong, as wealthy investors seek high-yielding opportunities in a low-interest rate environment, and as a $1.6 trillion Chinese insurance industry seeks to invest in even more real estate projects – as noted by Asia Society.

No. 4 – Cap Rates don’t move with interest rates

The potential for higher interest rates has stoked considerable fear of rising rates and property capitalization (cap rates), or the ratio of a property’s net operating income to market value, according to TIAA-CREF Asset Management. There’s a fear that rising interest rates increase cap rates, eventually leading to lower property values.

However, as TIAA-CREF said, “Cap rates and total returns are influenced by a wider network of variables beyond interest rates, including real estate fundamentals, capital flows, and investor risk appetite.”

Despite fears – most of which are unfounded – commercial real estate will remain a safer long-term investment with higher rewards and less risk than stocks and bonds.