By Jim Costello on August 5th, 2019
Will they, or won’t they? This was the question I was asked most often at U.S. industry conferences during the spring and early summer. The question was not focused on issues of television romances, but whether the Federal Reserve would be lowering the federal funds target rate as they did last week.
Earlier this year there was a sense of uncertainty and confusion about the state of the markets and deal volume suffered. People I talked with at conferences thought that perhaps the Fed lowering rates might help, but the slowdown was not just about the Fed. Broader uncertainty in the economy goes a long way to explain the weak start to the year.
The Fed did contribute to some of the recent uncertainty, but less so than other factors. The steady increase in the federal funds rate through the middle of 2018 had a delayed impact on the commercial property markets and challenged commercial real estate investors on their underwriting for debt early into 2019.
In line with the Fed action on the short end of the yield curve, the long end began to move last year. From June ’18 to November ’18, the 10yr UST climbed 20 bps. Commercial mortgage rates spiked into Q1’19 in response to the upward move in the long end of the yield curve. The 10yr UST then plunged 105 bps from November ’18 to June ’19. This wild ride on the long end of the yield curve eventually pulled down commercial mortgage rates.
If all the commercial real estate market had to deal with was the Fed trying to fine-tune the appropriate level for short-term rates as the impact of quantitative easing is unwound, then the market would not have as much to worry about. In the conference season this spring and early summer, investors pointed to many other issues hampering their decision-making.
Trade issues rattled commercial real estate investors early in the year and another popular question posed was whether the trade war with China would impact commercial real estate in the U.S. My take was that tariffs are just a tax on U.S. firms and consumers, and while higher taxes are not optimal, in the context of tax decreases in the recent past, we should muddle through. Longer-term, however, trade networks may shift outside the U.S.
Another element of uncertainty that rattled the market in the first half of 2019 was the impact of tax changes. Updates to the tax code in 2017 with respect to the deductibility of state and local income taxes (SALT) has led many to question the viability of commercial real estate investments in the most expensive parts of the U.S.
The narrative at some conferences was that everyone will leave the high tax states for places like Nevada and Texas. My take on that issue is that firms chase workers and labor pools. While certain small-scale operations can leave high-cost locations, the ecosystems that have created so much wealth in large metropolitan areas like New York, Boston, San Francisco and Los Angeles cannot be replicated quickly.
Investment activity should continue in these expensive, largely coastal areas. To the extent there were big deals in the office market in the first half of 2019, investors were still willing to pay high prices in these areas.
Again, while all the uncertainty in the markets in the first half of 2019 cannot be laid at the feet of the Fed, the Fed at this point is acting to limit uncertainty. Even before the announced 25 bps cut in the federal funds target rate, the long end of the yield curve had come down from recent highs. Transaction activity was already showing signs of picking up in the second half of 2019 with the announcement of some multibillion-dollar entity-level transactions in the industrial sector.
And then — just a day after the Fed’s decision — came the announcement of another round of tariffs which will likely end up as topic of discussion at the all the industry conferences this fall. By adjusting the few levers of the financial system which they control, the Fed can directly reduce some of the uncertainty in the economy that will come from realignments in trade because of new tariffs. However, if those realignments continue to be haphazard, there is only so much that the Fed can do.
A version of this article was first published in the Q2’19 edition of US Capital Trends. The next edition will be released August 21.