Midway through March, the Federal Reserve Board agreed to increase interest rates for the second time in as many months. Therefore, the next logical question is, where will cap rates go from here? In addition, do interest rates tend to stay at this level?
This boost will target the fund’s rate between 0.75 to 1 percent, and further increases will likely occur regularly. Since economic growth remains moderate, the Fed wants to proceed cautiously, but further rate hikes are expected in June and December.
What Will Happen to Cap Rates in The Future?
The commercial real estate market is worried that cap rates may rise in tandem with interest rates due to these hikes. The low-interest rate environment of recent years has led to the false assumption that rising interest rates always result in higher cap rates. However, the idea that they should move in tandem is generally flawed.
Interest rates increased dramatically from around 2% to 6% during one of the most recent periods of growing interest rates (from 2005 and 2007). Rate hikes in the mid-2000s were relatively small compared to those discussed now. However, historical analysis reveals that cap rates fell from the low 7% to the mid 6% throughout this time. During the same time frame, retail pricing increased from roughly $140/psf in Q1 2005 to around $170/psf in Q4 2007.
We must not allow ourselves to become oblivious to the truth that rising interest rates are also an indicator of a robust and expanding economy. Inflation and demand for commercial real estate, particularly in product categories that have enjoyed high rent and NOI growth, will increase as the economy recovers and interest rates rise. Although cap rates have increased slightly over the past eight months, most of the market is still experiencing rates between 5% and 6%.
In addition, Spencer Levy, CBRE’s head of research for the Americas, predicts that it is “likely to be muted by strong capital inflows to commercial real estate from foreign and domestic institutional sources,” which will slow the rate at which cap rates rise.
The government’s $4.5 trillion in assets purchased during the financial crisis may be one of the most problematic issues for real estate experts. Interest paid by the Fed on those assets grows in tandem with rate hikes. As reported by the CBO, federal interest payments are projected to increase by two over the next decade.
In the end, it means that banks are being compensated more to hold onto their surplus reserves, which, in practice, prevents those banks from lending hundreds of millions of dollars in reserves to the private economy. Ultimately, the Federal Reserve will have to maintain consistent modest rate hikes if they want to protect its interests.
Is This How Interest Rates Will Be from Now On?
It begs the question: are interest rates at their “new normal” now? They have been deficient for the past eight years. Thus, our economy has adapted to the rate levels that have become the new norm in their eyes. We are still looking at rates that are significantly lower than they were before the crash. Who knows, maybe we’ll never reach those heights again.
It demonstrates that a significant number of industries, and the economy as a whole, have adjusted to the present economic situation. As a consequence, it is quite improbable that the increase in interest rates that would be judged to be relatively minor will negatively impact the market for commercial real estate.
The critical point is that commercial real estate could benefit from these market conditions if interest rates remain relatively low and grow gradually, along with increased demand.
******************************
Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.