Lower Interest Rates Create More Structural Risk for U.S. Commercial Real Estate
On July 31, 2019, the U.S. Federal Reserve Chairman Jerome Powell announced that the Fed is cutting the federal funds rate by 25 basis points to approximately 2.25%. This move was widely anticipated by the market and Federal Reserve watchers, but public equity markets counterintuitively frowned on the cut, in part because Chairman Powell noted that the Fed would take a more cautious approach to rate cuts in the future.
Investors do not applaud traditional monetary policy because our economy has adjusted to the low rate environment of the past ten years. To use a party analogy, the Fed is not removing the punch bowl, but the party goers are at risk of drinking enough to regret the morning. This is especially true of commercial real estate. Lower rates have allowed everyone from institutional real estate companies to local developers to fund new construction and renovations cheaply. What has been good for the individual firm in the short run, however, has significant potential to overheat the sector.
We are seeing this already. As an asset class, U.S. office cap rates have fallen from recent peaks just below 10% in 2010 to around 6.25% today, while industrial cap rates have come down from about 8.5% to 6.3% today (according to Real Capital Analytics). The low rate environment we enjoyed following the financial crisis inflated commercial real estate asset values faster then effective rents, while rents in many markets are at their highest point.
Taken with the Fed’s rate reduction, these lower cap rates could spell problems for commercial landlords with higher credit risk tenants. The best way to prepare for the inevitable downturn is to adequately identify tenants that can weather a slowdown while getting stronger security on new leases. As the economy cools, companies will begin holding more and more cash in anticipation for challenges ahead, and obtaining stronger security will become more difficult.
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