Commercial Mortgages: With the Fed raising interest rates, commercial real estate interest rates are up | Business News
Federal Reserve Chair Jerome Powell was channeling the refrain “it’s only the beginning” from late 1960s and ’70s rock band Chicago’s hit “Beginnings” when he announced that the Federal Reserve was going to raise the federal funds rate .25%, but then went on to signal six more raises could be on the way this year and perhaps four more in 2023.
He doubled down last week when he indicated the Fed would perhaps move more aggressively against inflation if needed.
While the move and comments were in the range of investors’ expectations, the reality jarred the bond market, and the yield on the 10-year Treasury has moved upward .40% in two short weeks.
Since many commercial real estate lenders use that as their benchmark, interest rates are up from last month and, according to the to the John B. Levy & Company National Mortgage Survey, 5- and 10-year interest rates are now in the 3.75% to 3.80% range for lower leverage deals.
For commercial real estate investors, the battle against inflation comes with mixed feelings. Typically, real estate benefits in an inflationary environment as a good hedge. However, higher interest rates used to battle inflation are seen as a negative in an industry that is heavily debt driven.
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Interestingly, there is plenty of evidence to suggest that commercial real estate cap rates, which are used as a short-term value metric (representing the yield on an unleveraged property over a one-year period), are not all that correlated to the 10th -year Treasury.
Ryan Severino, the chief economist at JLL, has for many years pointed out the negative correlation between interest rates and cap rates.
You can go back to the 1980s and see multiple years where the yield on the 10-year Treasury was in fact above average cap rates. It is hard to imagine an investor purchasing an apartment complex for a 4% yield if they could buy a risk-free 10-year Treasury that yielded 5%.
However, that is what happened in the 1980s and the reason is that while a cap rate represents a value mechanism in time for commercial real estate, it isn’t very good at measuring other variables like future rents or the cost of capital.
Today, multifamily and industrial properties are getting scooped up at average cap rates that represent a very thin premium to the risk-free rate on the 10-year Treasury, but it is unlikely that the sudden and steep increase in interest rates will materially alter that trade. The reason is that investors believe rental and net operating income growth will increase returns over time and average out to a much higher premium.
The sharp rise in rates is much more likely to impact single tenant deals with low cap rates where leverage is being used. Those deals tend to have slower rental growth over time and are less likely to be either a hedge against inflation or show returns that justify the thin risk premium.
Richmond’s commercial real estate market continues to hum along. The challenge most often heard is that the cost to build new apartments is making it difficult to justify the development risk. This could lead to more rental growth as supply is constrained and demand continues to swell.
On another note, Apartment List recently released a report in honor of Women’s History Month. According to its research that takes into account recent data that reflects economic equity, business representation, affordability and community satisfaction for women, Richmond ranks sixth out of 80 for the Best Cities for Working Women.
John B. Levy & Co. partner and investment banker Andrew Little can be reached at alittle@ jblevyco.com.