The federal funds rate, as set by the Federal Reserve’s Federal Open Market Committee, has been at or near zero since the financial crisis that begin in 2008 which triggered a recession and, by most accounts, slow and gradual recovery. Because the economic recovery has lacked the huge upward surges usually seen following recessions, the Fed has seen it as very fragile and chosen not to raise the rates as it may cause a disruption. However, coming off of several positive jobs reports in a row, the Fed has sent numerous not-so-subtle hints that the first rate increase in years may be coming soon.
All things equal, keeping the federal funds rate low tends to lower the cost of borrowing funds for investing in commercial real estate, which then increases the yield from a property’s cash flow. An increase in the yield curve will then draw the attention of investors, increase demand and competition for properties, and ultimately lower cap rates and increase values.
If you were to ask 100 different economists, investors, or other experts of commercial real estate investment what effect a rate increase will have on the market, you will likely get 100 different answers. However, most would tell you it depends mostly on one thing – is the economic recovery real or is has it all been fueled by sustained artificially low rates?
The Fed is banking on sustained economic growth as the catalyst for the rate increase(s). If they are correct, then one (or several) small rate increases will likely have little effect for most commercial real estate assets. With sustainable economic recovery usually come business expansions, increased start-up activities, increased employment, wage increases, and manageable inflation. These factors increase demand for the users of commercial real estate which in turn lower occupancies and allow for gradual increases in rent and NOI growth. This growth in NOI can more than make up for the decrease in cash flow from increased borrowing costs and cap rates, thus allowing a property to still increase cash flow on a net basis and appreciate over time. This is clearly the opinion of the Fed, should they make the expected decision at their next Federal Open Market Committee to increase the federal funds rate.
So what happens if the Fed increases rates and we find out that their predictions of a sustainable economic recovery are wrong? Well, that’s the topic of my next blog so come back to check it out soon!
About Chris Palmer – Chris has been working with commercial real estate in Pensacola, Florida since 2010. He primary specializes in working with commercial real estate clients on development and investment related properties. Click here to read his full bio, or if you would like to contact him, you can call him at 850-610-8339 or email him at [email protected]
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