By Jim Costello on October 18th, 2017
Everybody and their brother expects that the Federal Reserve will raise rates in December. That’s the known. The unknown is the effect that a rate hike and the unwind of quantitative easing (QE) will have on property prices. Are the worst fears about the impact on prices overdone?
As I talk to commercial real estate professionals, the typical fear I detect regarding Fed activity goes like this: “the Fed’s gonna raise rates, the 10yr will go up 100 or 200 bps, cap rates will too, and we’re all dead”. I think those fears are overblown for a few reasons.
First, there’s been a substantive increase in the 10yr UST over the last year and cap rates haven’t rocketed. Second, forecasts for the 10yr UST have called for only modest increases1 and have largely overestimated future growth. Lastly, cap rates and interest rates never move in lockstep.
The 10yr UST bottomed out close to 1.5% in midyear 2016 and jumped to 2.5% in early 2017 with very little impact on cap rates for commercial properties. There was a slight 20 bps increase in cap rates for commercial properties in total, but part of that was noise and now cap rates are back where they were in midyear 2016.
The chart below highlights the fact that commercial cap rates barely nudged following the interest rate spike. If you are trying to digest this chart with the eyes of a financial economist, I know what you are thinking: you are thinking this chart is stupid because, by looking at cap rates and interest rates, it’s comparing apples to oranges. You’re also thinking that the proper comparison here to the 10yr UST would be the IRRs that investors expect going into a deal. However, there is an old saying: “if it’s stupid, and it works, it ain’t stupid”.
There are a number of rule-of-thumb type metrics that successful commercial real estate investors have followed over the years. One is that the cap rate for your investment should never be too close to the mortgage rate as most of your free cashflow would be covering debt costs. If some unseen economic scare savages commercial property rents, investors who did not follow that simple rule-of-thumb could see their investments end up in the graveyard.
The back of the envelope decomposition of cap rates in the chart highlights this type of relationship. The orange bars – the equity spread – measure the difference between commercial cap rates reported by Real Capital Analytics and the commercial mortgage rates for 7/10yr fixed rate loans. The grey bars – the debt spread – measure the difference between that mortgage rate and the 10yr UST.
On average since 2005 lenders have seen about 240 bps of spread over the 10yr UST while equity investors have come in with about 170 bps of spread above the mortgage rates. If interest rates increase roughly another 40 bps, these spreads could narrow to long-run averages with no impact on cap rates. Even a more aggressive move in the 10yr UST, say up 100 to 150 bps, could still partly be absorbed by these spreads without a one-to-one movement in commercial cap rates.
So, is it a happy ending, with nothing to worry about on interest rates so long as they do not increase too much? Not exactly. Like the end of the slasher movie when you think the bad guy is dead but he reappears in the mists just before the closing credits, there may be more trouble lurking.
In this case the worry is about the unwind of the QE program. Fed Chair Janet Yellen has been known to quote a study2 which estimates that the impact of the QE program was to push the 10yr UST 120 bps lower than what underlying economic conditions would have suggested. Will the unwind push it up to the same degree? That issue is a big, scary unknown. The QE program was new and unprecedented. There is no previous unwinding to use as a benchmark.
Consider this fact, however. Roughly 40% of the Fed balance sheet is now composed of mortgage-backed securities. These are residential securities and not tied to the commercial real estate industry but for some investors this asset class can act as a bit of a substitute. As the Fed starts to unwind these assets, it will do so slowly, at first allowing only $4 billion worth of mortgage-backed securities to mature every month. Eventually the Fed will be selling these securities. One scary thought is that there will not be enough buyers to go around if the Fed moves too quickly which could depress prices.