Commercial Mortgages: With Fed Rising Interest Rates, Commercial Real Estate Interest Rates Are Rising | Economic news
Federal Reserve Chairman Jerome Powell was channeling the “this is just the beginning” refrain from the Chicago rock band’s hit “Beginnings” of the late 1960s and 1970s when he announced that the Federal Reserve was going to raise the federal funds rate by 0.25%, but then went on to signal that six more increases could be on the way this year and possibly four more in 2023.
He doubled down last week when he indicated the Fed might act more aggressively against inflation if needed.
While the move and commentary matched investor expectations, reality rocked the bond market and the 10-year Treasury yield rose 0.40% in two short weeks.
Since many commercial real estate lenders use it as a benchmark, interest rates are up from last month and, according to John B. Levy & Company’s National Mortgage Survey, interest rates over 5 and 10 years are now at 3.75%. 3.80% for low leverage trades.
For commercial real estate investors, the fight against inflation comes with mixed feelings. Typically, real estate benefits in an inflationary environment as a good hedge. However, higher interest rates used to fight inflation are seen as negative in a highly indebted industry.
People also read…
Interestingly, there is a great deal of evidence to suggest that commercial real estate cap rates, which are used as a measure of short-term value (representing the return on an unleveraged property over a one-year period), do are not quite correlated to the 10-year Treasury.
Ryan Severino, JLL’s chief economist, has pointed out the negative correlation between interest rates and capitalization rates for many years.
You can go back to the 1980s and see several years where the 10-year Treasury yield was actually above average cap rates. It’s hard to imagine an investor buying an apartment complex for a 4% return if they could buy a risk-free 10-year treasury note that was yielding 5%.
However, that’s what happened in the 1980s and the reason is that while a capitalization rate is a value-over-time mechanism for commercial real estate, it’s not very good at measuring d other variables such as future rents or the cost of capital.
Today, multi-family and industrial properties are fetching at average cap rates that represent a very small premium over the 10-year Treasury risk-free rate, but the sudden and steep rise in interest rates is unlikely to interest significantly alters that. Trade. The reason for this is that investors believe that growth in net rental and operating income will increase returns over time and result in a much higher premium on average.
The sharp rise in rates is much more likely to impact single tenant contracts with low cap rates where leverage is used. These transactions tend to have slower rental growth over time and are less likely to be an inflation hedge or post returns that justify the low risk premium.
Richmond’s commercial real estate market continues to buzz. The most commonly heard challenge is that the cost of building new apartments makes it difficult to justify development risk. This could lead to more rental growth as supply is limited and demand continues to inflate.
On another note, Apartment List recently released a report in honor of Women’s History Month. According to her research that considers recent data reflecting economic equity, business representation, affordability and community satisfaction for women, Richmond ranks sixth out of 80 for best cities for working women.
John B. Levy & Co. partner and investment banker Andrew Little can be reached at [email protected]