Did the Fed Indicate Cap Rates Will Rise?

According to the Wall Street Journal the last time the central bank had its short term interest rate more than nominally above zero, was some 2400 days ago. At that time, US Airways flight 1549 landed safely in the Hudson; the Steelers beat the Cardinals in the Superbowl; it was a blue moon ago! 

Seriously, if you are into blue moons, Friday July 31^st actually is a blue moon. 2009 was also before current Fed Chair, Janet Yellen had been sworn into her post. Now in the heat of the summer, after their most recent meet, there is speculation that the Fed may consider setting the clock back to pre-2009, and raise the interest rates.

Indications are speculative. Bill Belichick gives away more in his press conferences than Yellen does in hers. Still with three meetings left in the year, and the major economic indicators going from yellow to green, the Fed may consider a raise. If that happens, what will happen to the commercial real estate values and their capitalization rates?

The capitalization rate, or cap rate, is on indicator of a property’s value in the market. It acts like a yield on a bond. Baked into a cap rate is the risk profile for the property, the buyers assessment of value and the buyer’s cost of capital. As cap rates increase values of properties go down. So would it follow that a rise in the central bank rate would indicate a rise in cap rates and a decrease in commercial real estate? Spoiler alert: No.

Recent Studies by Forbes and Morgan Stanley both agree that while this rule may work in a macro economics class, it will likely not be a factor for us this coming Fall. The reasoning lies with the complexity of the system. If the Fed raises the base rate, banks will not directly raise their rates on par. There is huge competition today in the debt markets. At last check there are 9 banks in Bedford alone not counting the two new branches about to open! That does not even get into the other lenders for commercial investment real estate, such as CMBS, life money and other players.

Additionally in order for property values to decline, we would have to go back to a golden rule of Econ 101, supply and demand. Quality investment and user assets are still at a premium. New construction, while increasing in New Hampshire, is not creating an oversupply of for sale assets on the market. IF the Fed raises rates and IF banks respond accordingly, the market is still tight with quality property and full of investors. The likelihood that rates will rise enough to chase people out of commercial real estate and into risk free returns such as CDs or bonds, is the same as Belichick and Yellen singing a duet in that same press conference.

Of course all of this speculation is both macro and in the near future. Interest rates take time to work through the system and get from Washington down to the local appraiser valuing an asset. Additionally, if rates do rise and banks respond accordingly, we may see some owner occupants leave the buying game and decide it is cheaper to lease. But that too takes time to work through the system. Until then we will monitor both Yellen and Belichick for signs of what the Fall will bring. 

Written by Chris Norwood, NAI Norwood Group, cnorwood@nainorwoodgroup.com.