The economic slowdown that inspired the Federal Reserve to pause after two years of interest rate hikes could soon escalate to a recession, economists warn. Meanwhile, commercial real estate professionals welcomed theas a sign that the brisk volume in investment sales will continue uninterrupted.
On Tuesday, the Federal Open Market Committee (FOMA) let the overnight Fed funds rate stand at 5.25%. The committee had raised the rate 25 basis points at each of its previous 17 meetings since June 2004.
The move was largely anticipated, as evidenced by the 10-year Treasury yield’s drop to below 5% in the week preceding the meeting. Nonetheless, the Fed’s announcement brought a sigh of relief from most commercial real estate professionals, including Eric Anton, senior managing director at New York-based Eastern Consolidated, a full-service real estate investment services firm.
“Most buyers and owners view this in a positive way,” Anton says. “It’s viewed as good news, helpful to the industry.”
Current interest rate levels are low enough to allow complex lending structures that incorporate a senior loan with mezzanine, preferred equity and other forms of debt to finance large, Anton explains. Industry players had worried that further rate tightening by the Fed would increase the cost of capital in those high-leveraged deals and make them more difficult to complete. But the Fed’s decision to hold the line keeps the door open for complex lending structures.
Some market experts forecast moderate economic growth through the end of this year. “That will mean continued moderate increases in demand for commercial space, which is a net positive,” says Jamie Woodwell, senior director of commercial/multifamily research at the Mortgage Bankers Association.
Economists are less optimistic, however, due in part to the flat yield curve. The 10-year Treasury yield was 4.9% on Aug. 9, below the 5.25% Fed rate. Normally, long-term rates are higher than short-term rates, but the 10-year Treasury yield has bounced above and below 5% for weeks. If investors interpret the Fed’s decision as an indication that inflation is in check, the long-term yield may drop further.
The 10-year Treasury rate will move closer to 4.5% in the coming weeks, making the inverted yield curve more pronounced, predicts James Smith, chief economist at Parsec Financial Management Inc. in Asheville, N.C. Historically, an inverted yield curve lasting a month or more has been a prelude to economic recession. “Why should 2007 be any different if this happens?”
An inverted yield curve does strain the banking system, agrees economist Anthony Pierson, managing director of portfolio management at Cornerstone Real Estate Advisers. But Pierson isn’t convinced the current curve will remain inverted for long. At times, the low yield on long-term bonds can suggest that investors expect the economy to stumble, he explains. But in this case, the low rate more likely reflects a high demand for the security of bonds as investors avoid volatility in the stock market, adds Pierson.
Rather than emphasize the yield curve, Pierson advises commercial real estate investors to keep an eye on slowing employment growth. The 113,000 jobs created in July was below the 124,000 jobs added in June and well below the 145,000 economists had predicted — the fourth straight month that employment gains fell short of expectations.
“That’s the thing that could hurt real estate investors the most,” Pierson says. “Right now demand is good for most property types, from both a capital perspective and a tenant perspective, but if employment slows down, that puts some of the demand at risk.”
With high energy costs, a cooling housing market and the effects of previous Fed rate hikes slowing the economy, commercial real estate developers will slow the pace of new development, says Dana Johnson, chief economist at Comerica Bank in Detroit. “The pricing of loans isn’t going to be a problem,” however, he says. “Some lenders may become more cautious, but the pricing is going to be pretty attractive.”
Even in the event of a recession, economists say there isn’t great cause for concern on the real estate front because developers have kept supply in check since the 2001 recession and technology bust. Economist Smith predicts the coming recession will be like its 2001 predecessor — swift and mild — but without the accompanying office glut that resulted from a correction in the technology job market.
“Commercial real estate markets will be very strong for the rest of 2006 and well into 2007, perhaps for the entire year,” Smith says. “They'll fall in 2008 and turn back up in 2009 and beyond.”