The Fed Finally Lifts Off: What Rising Rates Mean for Commercial Real Estate

What happened?

On Wednesday, March 16, 2022, the Federal Open Market Committee (FOMC)—the body charged with deciding on and implementing monetary policy—voted to raise the federal funds rate¹ by 25 basis points (bps). Updated projections from the FOMC suggest that six additional rate hikes of 25 bps each are likely over the course of this year, followed by another three rate hikes in 2023. The FOMC also suggested that tapering is likely to commence soon, but the Fed will continue to reinvest maturing proceeds for now. While not in the official statement, Chair Powell commented that there could be “significant balance sheet run-off by the end of the year.” 

How did we get here? 

Let’s begin in March 2020. Following the onset of the global pandemic, the FOMC lowered the federal funds rate to the zero-lower bound—effectively the 0% to 0.25% range. The last time the Fed had made a similar move was during the financial crisis of the late 2000s, lowering and then keeping the fed funds rate in zero-lower bound territory for the next half decade. That the Fed reacted so aggressively when the pandemic surged (restarting quantitative easing, introducing emergency credit facilities), it was seen as evidence that the central bank—and by extension the FOMC—would do whatever it took to support the economy through hard times.  

Fast forward to early 2022 and economic growth is no longer the Fed’s primary concern. The pandemic has become less disruptive from those spring days of 2020, and in 2021, as the rate of vaccinations crept up, the economy reopened and it was clear that a spending boom, different from the one resulting from the immediate reopening in summer 2020, was just being unleashed. Indeed, real GDP recovered to its pre-pandemic level in March 2021—11 months after the trough—and nonfarm payrolls regained 19.9 million jobs, leaving employment in the U.S. only 1.4% below pre-COVID levels as of February 2022. With the consensus calling for about 4 million new jobs this year and job openings at a record high, it is clear that the labor market is roaring back towards the FOMC’s other mandate, which is full employment. 

Approximately 64% of Headline Inflation Due to Energy, Supply Chains, Reopening

How this recovery is different from the last  

It can be dangerous to say “this time is different,” but things are different now from the post-GFC recovery. The post-GFC expansionary cycle was characterized by financial havoc and contagion, tight credit conditions, deleveraging and sluggish growth, all of which resulted in below target inflation. The pandemic recovery, conversely, has been free of those characteristics. Instead, swift and historic fiscal and monetary support avoided poor credit outcomes. Regulatory changes behind the scenes provided flexibility to the financial system to adapt. And various legislative and regulatory actions provided significant income support for state and local governments, businesses and households. But the downside of the rapid response and recovery has been a demand surge at a time when supply chains are still scrambled, resulting in high rates of inflation for many goods and services. Fortunately, many aspects of inflation will not last into perpetuity. Oil and food prices, for example, will not go up forever. They are always volatile (and this was even true before Russia’s invasion of Ukraine). Supply chains will eventually stabilize. Stimulus-driven demand will wane. All these are reasons why, in part, both the market and consumers have remarkably stable longer-term inflation expectations. Moreover, part of the reason long-term inflation expectations remain anchored in the 2% range is due to the belief that the FOMC will respond as it is now. Indeed, financial markets are pricing in greater than 85% odds that the federal funds rate is in the 1.75% to 2% range by the end of 2022. The idea is that higher rates will slow demand and bring inflation back under control. In other words, it is not a given that expectations remain anchored: they hinge on the faith placed on the FOMC to achieve its stable inflation mandate. 

Market Expectations for Dec 2022 Fed Funds Rate

What does it mean for CRE? 

In our view, the vote by the FOMC to raise the federal funds rate will ultimately benefit the long-term health of the property markets. The fundamental intent is to reduce the risk that elevated inflation will become entrenched, forcing the Fed to hike rates more aggressively in the future and potentially sparking a recession, which would clearly be a worst outcome for many sectors including property. The gradual move now by the Fed is a necessary step to help achieve the second part of its dual mandate: achieving price stability, a precondition for a sustainable healthy labor market. Ultimately the confluence of these two objectives being achieved will help to sustain the CRE expansion. 

With real GDP expected to grow around 3% this year and the market already pricing in multiple rate hikes by the FOMC, here are a few points of emphasis:  

• Real growth around 3% is well above both historic norms and the economy’s long-term potential growth rate. This environment will create demand for all forms of property, which means improving fundamentals across most markets and assets. 
  
  
• Economy-wide profit margins are at record highs, and corporate and household balance sheets are in record shape. There is room to absorb higher capital costs without derailing growth. 
  
  
• Interest rates remain very low, and in all probability, they are lower today than they will be in one- or two-year’s time. Floating rate debt is going to become more expensive: locking in still attractive longer-term fixed rates is a strategy to consider.  
  
  
• The financial market knew this was coming and had already priced in seven rate hikes this year. The 10-year Treasury yield has already captured these expected rate movements, which is partly why it has drifted up in recent weeks. Chair Powell even alluded to that while monetary policy acts with a lag, recent movements in the market have essentially helped the Fed and began some of the tightening effects sooner. This is what Fed credibility looks like.  
  
  
• Rate liftoff—the term to describe FOMC’s raising of rates from a near zero level—usually creates jitters initially. In the 11 cycles since WWII, the average length of time between liftoff and a peak rate, let alone the start of a downturn, was 45 months. Indeed, in Powell’s words, “the odds of a recession occurring in 2022 are quite low.” In our words, less than a 10% probability. Play the odds.  
  
  
• Historically, liftoff has been followed by periods of economic growth. On average, from the start of rate increases to peak, real GDP has grown by 15.3%. Growth is even higher when measured from the start of rate increases to the start of a downturn—real GDP has averaged a 19.2% increase (peak rates do not always coincide with the end of an expansion). 
  
  
• Finally, the love affair between interest rates and cap rates has been anything but straight forward over the years. There is essentially no correlation between changes in the federal funds rate or the 10-year Treasury rate and property cap rates. However, the narrower spreads are when rates change, the more likely cap rates are to rise. Said differently, the context of changes in interest rates is critical. Recently, risk aversion has been rising in tandem with interest rates as reflected in widening spreads in corporate bond markets and declining price-to-earnings ratios in global equity markets. CRE debt and equity pricing are likely to come under pressure with this being felt unevenly across sectors and geographies depending on the willingness of investors to accept smaller risk premia. 

¹ The interest rates that banks pay to borrow or lend each other overnight.