While the anticipated path of future Fed rate hikes is likely not in and of itself a significant threat to commercial real estate cap rates, wise investors will keep an eye on two interest rate-related factors that could negatively impact cap rates and catch the myopic investor off guard.
As noted previously, the Fed does not act in a vacuum; rather, it operates in something akin to a canoe with its fellow central bank policymakers, navigating a multitude of economic cross-currents while trying to guide global interest rates. Perhaps most importantly, the combined effects of central bank actions significantly impact global capital flows and asset values. If, for example, the Fed raises short-term rates 25 basis points and one or all of the three other central banks lower rates 25 basis points, the magnitude of the impact on global capital flows, currencies and U.S. Treasury rates is amplified, much like if one person in a canoe starts paddling in one direction while one or all of the other passengers begin paddling in the opposite direction, collectively creating instability and uncertainty. This can cause global capital flows to suddenly and significantly reverse, leading to capital flow and currency issues for countries, most notably emerging market economies that are dependent on foreign investment. It can also significantly impact commodity values, again most impacting emerging market economies all while investors nervously observe the divergent actions and resulting impact on capital flows, currencies, asset values and heightened uncertainty and instability. Thus, it is critical not to view the Fed in isolation, as if it is alone in a kayak controlling its own destiny, but rather in a canoe with its actions amplified by its fellow paddlers.
Central bank policymakers are not the only ones in the canoe, as investors are also feelings increasingly on edge and queasy as a result of the turbulent financial market currents from the second half of 2015. Investors experienced a significant increase in equity market volatility, both domestically and globally, in the second half of 2015, with a near doubling of intraday stock market volatility in August and September in the United States. High yield debt also landed on the maps of most investors in the second half of 2015, as did increased queasiness in anticipation of the uncertain severity of the impending junk bond rapids.
As a result, a significant shift of investor sentiment in fixed income markets occurred, significantly elevating risk premiums between U.S. Treasuries, high investment grade corporate bonds and low-investment grade corporate bonds. In October, U.S. Treasury yields declined 23 basis points on a year-over-year basis, while corporate debt on the low end of the investment grade spectrum increased more than 65 basis points, nearly a 90 basis point increase in the spread between U.S. Treasuries and the low-end of investment grade corporate bonds. This is important not only because of the substantial shift in a relatively short period of time, but because it occurred within the investment grade portion of the bond market.
While the magnitude of future Fed rate increases will likely be gradual and have a minimal direct impact on cap rates, there are other effects of Fed policy that can quickly and negatively impact cap rates. Similar to central bank policymakers, as real estate investors we are not in a kayak navigating the economic environment and capital markets by ourselves, but rather in a canoe impacted by the actions of many others such as central bank policies, some of which may be significant. It is not the gradual, expected change that creates the problem, but rather the significant and often overlooked potential changes.
Implications for commercial real estate investment strategies
With a variety of meaningful factors constraining the path of future Fed rate increases, a likely less than 1:1 increase in long-term rates and expectations of continued strong capital flows to commercial real estate somewhat mitigating the impact of future rate hikes on cap rates, it is anticipated that the impact of future hikes on cap rates in and of themselves will be manageable, especially in light of anticipated capital flows to commercial real estate and commercial real estate income growth. However, as central banks increasingly begin to paddle in divergent directions and investor unease increases, the possibility of unexpected shifts in liquidity and cap rates increases. Prudent investors, aware that commercial real estate’s role within a larger multi-asset class portfolio is that of a return stabilizer, will navigate markets with greater depth as opposed to straying off course into markets having elevated liquidity today, but which are prone to quickly finding themselves facing shallow liquidity, and very importantly, liquidity levels that recover more slowly following economic turbulence.