How the Federal Reserve Impacts Commercial Real Estate

July 6, 2021
How the Federal Reserve Impacts Commercial Real Estate

Having a deep understanding of local markets is essential in commercial real estate to spot new opportunities and create strategies. But the investor who stays on top of macroeconomic forces can make preemptive strikes and defensive plays before anyone else. That’s why we’ve created a guide on how the Federal Reserve impacts commercial real estate. To give you an inside look at how the central bank of the United States—one of the most powerful agencies in the world—impacts your investments. In this guide, we’ll provide a background into the Federal Reserve system, its influential Funds Rate, and how a global financial system affects your bottom line.

Purpose and Structure of the Federal Reserve

The Federal Reserve (or simply “the Fed”) was established on December 23, 1913, when President Woodrow Wilson signed the Federal Reserve Act into law. The idea was to reform the nation’s banking system and prevent the financial disasters prevalent at the time. According to the Fed’s website, modern day responsibilities include:

  • Promoting the stability of the financial system and seeking to minimize and contain systemic risks through active monitoring and engagement in the U.S. and abroad;
  • Promoting the safety and soundness of individual financial institutions and monitoring their impact on the financial system as a whole;

As the central bank of the United States, it’s composed of three entities:

  1. The Board of Governors
  2. 12 Federal Reserve Banks
  3. The Federal Open Market Committee (FOMC)

Source: The Federal Reserve SystemThe Board of Governors and the Fed Chair are appointed by the President and confirmed by the Senate. Heads of regional banks are chosen by local boards of directors and are meant to represent their communities.

The Federal Funds Rate

The main mechanism the Fed employs to influence the U.S. economy is the Federal Funds rate. This is the rate at which banks lend “reserve balances” to other banks on an overnight basis and is a vital barometer of the American economy.The Funds Rate is set by the FOMC, which meets eight times a year to evaluate its monetary strategy, based on its outlook for growth and inflation. FED Latest Interest Rate Change Change datePercentage September 26 20182.250 % June 13 20182.000 % March 21 20181.750 % December 13 20171.500 % June 14 20171.250 % March 16 20171.000 % December 14 20160.750 % December 16 20150.500 % December 16 20080.250 % October 29 20081.000 %Source: Global RatesContractionary Monetary PolicyAs of September 2018, the Fed has increased the Funds Rate three times. We are now in what is called a contractionary monetary policy—a period in which the FOMC wishes to slow the economy. It’s a little more complicated than simply raising the rate. In fact, what the Fed does is sell government securities to individuals and institutions. This decreases the amount of money left for commercial banks to lend. It effectively takes money out of the system, thus increasing the cost of borrowing and increasing interest rates, including the federal funds rate.When the cost of debt goes up, individuals and businesses are discouraged from borrowing, and will opt to save their money. The higher interest rate means that the interest in savings accounts and certificates of deposit (CDs) will also be higher. To take advantage of the savings rates, entities will spend less in the economy and invest less in the capital markets, thereby, slowing inflation and economic growth.Expansionary Monetary PolicyWhat we saw back in 2008 was known as an expansionary monetary policy. The FOMC increases the money supply to lower the target rate when the economy is sluggish and inflation is benign. This is partly why we’ve seen a 0% Funds Rate in past few years. In this case, the Fed purchases government securities through private bond dealers and deposits payment into the bank accounts of the individuals or organizations that sold the bonds. The deposits become part of the cash that commercial banks hold at the Fed, and therefore increase the amount of money that commercial banks have available to lend. Commercial banks actively want to loan cash reserves and try to attract borrowers by lowering interest rates, which includes the federal funds rate.When the amounts of funds available to loan increases, interest rates go down. A decrease in the cost of borrowing means that more people and businesses have access to funds at a cheaper rate. This leads to less savings and more spending. And that increase in spending fuels the economy, leading to lower unemployment.Quantitative EasingA modern and rather unconventional monetary policy used by the Fed during the crisis and the aftermath is something called quantitative easing. This is where the Fed enters the marketplace to purchase bonds, effectively lowering interest rates and increasing the money supplyThe Fed purchased treasuries and mortgage-backed securities, but has since stopped and is starting to slowly sell-off that portfolio.

The Global Effect

The monetary policies of the Federal Reserve have a strong influence on the global economy. For example, its Fund Rate is closely watched by the Intercontinental Exchange London Interbank Offered Rate (LIBOR). This is a benchmark rate used by some of the world’s leading banks to charge each other for short-term loans. LIBOR is important because over $250 trillion of instruments and derivatives are pegged to it. That’s a quarter of a quadrillion dollars! A huge number considering the entire US economy for a year’s output is about $10-$12 trillion. LIBOR is administered by the ICE Benchmark Administration (IBA) and is based on five currencies: the U.S. dollar (USD), euro (EUR), pound sterling (GBP), Japanese yen (JPY), and Swiss franc (CHF). Did you know?In recent years, the LIBOR has seen a few price rigging scandals that has prompted the U.S. to switch to the Secured Overnight Financing Rate (SOFR). This is an overnight cost of funds rate set by the New York Fed, based on actual transactions, instead of a survey. The British are going to have their own rate, often called S-O-N-I-A, the Japanese will have their own floating rate called T-O-N-I-A and LIBOR is scheduled to go away in the end of 2021. So while the world is entering a new transition point, these new cost of funds will still closely track the Fed rate because the Fed is so dominant.

Ultra-Low Rates and Ultra-Low Inflation?

As mentioned above, the Fed aims to keep its citizens employed and prices stable. As a benchmark, the Fed uses 4% unemployment and 2% inflation as its optimal rates for a stable economy. We are in an era of unprecedented low rates. Unemployment is low, interest rates are low and surprisingly, inflation remains flat. (Only recently, has inflation began to rise.)The chart below shows inflation collapse in 2008. As a result of the crisis, the Fed enacted expansionary monetary policy and dropped the Fed Funds Rate to 0%. U.S. Inflation Rate by Year from 2005 to 2020YearInflation Rate YOYFed Funds RateBusiness Cycle (GDP Growth) 20053.4%4.25%Expansion (3.3%)20062.5%5.25%Expansion (2.7%) 20074.1%4.25%Dec peak (1.8%)20080.1%0%Contraction (-.3%)20092.7%0%Jun trough (2.8%) 20101.5%0%Expansion (2.5%)20113.0%0%Expansion (1.6%)20121.7%0%Expansion (2.2%)20131.5%0%Expansion (1.7%)20140.8%0%Expansion (2.4%)20150.7%0.25%Expansion (2.6%) 20162.1%0.75%Expansion (1.6%)20172.1%1.50%Core inflation rate 1.8%. The current rate is updated monthly.20181.9%2.0%Forecast. Core rate 1.9 %20192.0%2.5%Forecast. Core rate 2.0%20202.0%3.0%Forecast. Core rate 2.0%Source: The BalanceOn December 17, 2015, Janet Yellen came out in a press conference and raised the rate. The markets were shocked having grown used to seven years of a basically a 0% Fed rate and ultra-low cost of funds, which some people called the “punch bowl effect.” And what a party it was. With the DOW hitting record-high numbers, unemployment falling, and growth seen in all sectors of the economy, the market was indeed shocked to have the punch bowl pulled away. The Fed then went on to increase rates in 2015, once in 2016, and three times in 2017. The third raise of 2018 occurred in September which brings the rate to 2.25%. The Fed expects to continue this trend as it closely watches the price level within the economy. Instead of the Consumer Price Index (CPI), the Fed looks at the Consumption Expenditures (PCE) since it believes this basket of goods is more accurate for a typical American family.

Impact on Commercial Real Estate

Everything we’ve discussed so far in this guide affects local markets you’re invested in. When inflation goes up for example, cost of goods rises, including building materials, construction costs, and labor. So it’s important to stay on top of the macroeconomic trends. But perhaps the most direct impact felt by investors is the cost to borrow. The key thing to remember about the Funds Rate is that it is a floating rate — an overnight borrowing rate that the financial markets keep a close eye on. The banks use it to set their prime rate and price their products, including credit cards, auto loans, home loans, and yes, even commercial real estate loans. Having a floating versus fixed rate depends on your business plan. In this industry, floating rate loans are for construction or renovation of properties and fixed-rate loans are for stabilized properties. And there's also certain borrowers who put a floating rate loan on a stabilized property to stay flexible. They want to be able to sell without a hefty prepayment that comes along with a fixed rate. These real estate investors borrowing on a floating-rate basis do see their rate go up every time the Fed raises the Funds Rate. So most investors with this type of rate are definitely racing to complete their business plans and lock in a fixed rate before they rise further. Fixed-rate borrowers won’t see a change if the rate is locked. These rates are based on treasuries and treasury buyers and sellers often watch LIBOR and the Fed for clues and direction. The proper rate for the Treasury is really set by the appetite for buyers at that rate. So the more people buy treasuries, the lower the rate goes. The Treasury Rate is really an expectation by the markets as to long-term inflation and growth. So we've had a little disconnect lately. We've had the Fed raising rates, LIBOR going up, floating rates going up and fixed rates staying low. An Expert’s PerspectiveDavid Pascale is SVP at George Smith Partners where he oversees the placement of nearly $4 billion capital into commercial real estate. He offers his expertise via a weekly column in FINfacts known as the hugely popular “Pascale’s Perspective,” where you can get detailed information on trends affecting the United States Real Estate Markets by combining national/international macro overviews with specific microeconomic events.Mr. Pascale shares his thoughts on the Treasury rate. The reason the Treasury has not been moved up more I think is two major reasons. One is the relative value to the German bonds in the Euro. Because the Euro is a little behind the U.S. in growth and their central bank is still doing ultra accommodative measures such as buying bonds etc, which our Federal Reserve has stopped doing. So the German bond ten-year bond is about 0.4 right now, and the relative value between the German bond and the U.S. Treasury, the U.S. Treasury is at 240 basis point premium on that. Until the German bond breaks out of that range, I feel that the Treasury will remain under 3% because there's always going to be a buyer that sees the Treasury as a safe asset. The other thing that affects Treasuries is U.S. deficits which are really exploding right now and that’s something for everyone to watch. Because at some point the supply-demand ratio can cause a problem. If there's not enough buyers for our bonds, the yields will spike dramatically but so far that has not happened.Historical Borrowing Rates for Commercial MortgagesThey didn’t call it the “housing crisis” for nothing. Real estate was hit hard in 2008. Since then, the Fed has focused its policy to incentivize private investments in this area. For many years since 2008, the LIBOR was virtually at 0% or 0.25%. And so a typical LIBOR loan is anywhere from 1%-6% percent above the LIBOR. LIBOR borrowers have seen about 1.75% increase in LIBOR during that time, but interestingly, spreads have compressed slightly.From 2012 to 2015, fixed-rate loans from both Fannie Mae and Freddie Mac, 10-year CMBS loans, and 10-year life company were being done in the high threes—3.75 to 3.8 or the low fours. Today, rates are 4.5%-5.25%, so there's been about a 1%-1.5% increase in fixed-rate loans overall. The big banks have been aggressive for low-leverage loans for good sponsors. They've been lending in the high 100 into the 200s for good transactions. Increased Competition from the Unregulated SectorWhen it comes to floating rates, there's been increased competition. Recently, there has been a massive amount of money in the unregulated debt fund market. This elevates the competition for transactions and loan volume that forces some of the major banks to cut spreads. Private lenders will raise equity from hedge funds, pension funds, or giant family offices, borrow money on a bank line over LIBOR—at a very low rate—as low as LIBOR plus 100-200 basis points and then lend the money out at LIBOR plus 200- 500.The equity in the fund can get a return anywhere from 8%-11%. And that equity has been willing to take a lower return, which results in lower rates for borrowers. The Collateralized Loan Obligation (CLO) MarketThere is also a securitized market for floating rate loans. The collateralized loan obligation market, which is like a floating rate CMBS for summary purposes. That market has been very active lately because as rates go up, there are more buyers for LIBOR-based securities because they can protect themselves against rate increases. The CMBS bond buyer buys a fixed-rate, 10-year security. This is a higher risk instrument with a lower yield than a Treasury. Conversely, as the Fed raises rates, the CLO market has been on fire lately, with tons of buyers and which has compressed spreads. In an inflationary environment, where interest rates are going up, having that ten-year fixed rate is far more attractive than floating rates.

Real Estate Investors Deal with Inflation

“I still think commercial real estate is an attractive investment because it allows you to go at all levels of the risk spectrum.” — David Pascale, SVP at George Smith PartnersWe asked David Pascale of George Smith Partners to share his thoughts on what it means to be a real estate investor moving into 2019. Mr. Pascale believes that real estate has served as an inflation hedge from post-World War 2 right up to around 2006. There are many reasons for this. “Other than the tax benefits with depreciation, the general idea is that as prices go up, rental rates go up as well,” Mr. Pascale says.“I still think commercial real estate is an attractive investment because it allows you to go at all levels of the risk spectrum. From low-risk apartments that receive the ‘first dollar’ from consumers, to industrial buildings playing a key supply chain role in the internet age.”Going forward, Mr. Pascale envisions a lot of investing being “deal-specific and market-specific, since different parts of the country are growing at different levels.” He states, “I think that there’s been a continuing kind of wealth gap in America, where there’s the very rich and the working poor.” So he sees investors betting on working-class stores— the discount stores, the daily needs stores—in particular markets across the country. On the other end you have investments in the very top 1%—the ultra luxurious category of high-street retail for example. “So there’s a lot of trends to watch as America changes and you want to buy real estate that is going to be functional five years from now,” Mr. Pascale says. “You have to look into the future and watch for trends. Especially in the case of retail right now, what will be a viable piece of real estate.”

The Final Forecast

Mr. Pascale believes a December rate hike is still on the table, despite what some investors think. After the third this September, Mr. Pascale expects 2-4 further increases in 2019. As investors, the best thing to do is watch the markets. But also trade agreements (or trade disagreements), including tariffs and the like. The recent trade deals between the U.S., Mexico, and Canada is being called “the new NAFTA” and Mr. Pascale believes it is reassuring for the U.S. “A lot of people don’t realize that Canada is our biggest trading partner and Mexico is a massive trading partner,” Mr. Pascale says. “The big kahunas in this world are watching the U.S.-China trade talks which haven’t been going well, but there’s some speculation of a big breakthrough coincidently timed for the November elections.” Either way, those talks are being watched closely as well. “Finally, the US and Europe recently came up with a major agreement. So that was something that could produce a lot of headwinds to the economy’s trade,” Mr. Pascale says. “We’re watching the midterm elections and political tumult in Washington and some economists think that gridlock is the best thing because things just keep puttering along.” Speaking of Washington, Mr. Pascale would like to see a major infrastructure bill come out of there to help real estate and all other aspects of life in America. “I think a lot of the highway system we built in the 50s and 60s needs an upgrade with new trucks and everything like that.”The tailing effects of the recent tax cuts saw a big boon to corporations but Mr. Pascale wonders whether corporations are investing that money or are they just doing stock buybacks? “Stock buybacks will be a short-lived spike, real investment in the economy, new equipment, payroll bonuses for the working man and women are what was hoped for and we’ll see how that turns out,” Mr. Pascale says. *If you like this post, be sure to enroll in our free six week course on the fundamentals of commercial real estate investing — RealCrowd University.*

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