5 min read
Key takeaways
- The path ahead is unclear for interest rates as incoming data and financial conditions evolve.
- Ongoing tension between what the Fed says and what the market believes further muddles forecasts.
- Multifamily investors should look at multiple economic and business factors as they consider real estate hedging options.
Soaring interest rates. Volatile markets. Economic uncertainty. Investors have been hit on all fronts lately.
While the Federal Reserve indicated in May that it might pause its streak of rate hikes, there’s still plenty of work to do to tame inflation. Here are a few things to keep in mind about interest rates.
How the Fed affects short- and long-term interest rates
As always, it’s important to differentiate between short- and long-term interest rates and how the Fed’s actions impact each.
- Short-term interest rates are directlyaffected by the Federal Reserve. As the Fed’s primary tool for influencing interest rates and the economy, the federal funds target range directly drives other short-term market rates such as prime and SOFR.
- Medium- and long-term interest rates—such as yields on Treasury notes and bonds, interest rate swaps and corporate bonds—depend on the market’s long-term expectations of inflation and the direction of the economy. Day-to-day supply and demand can also drive these rates. Because market participants with a wide range of views drive long-term interest rates, they’re subject to more volatility.
Forecasting these rates can be particularly difficult because the Fed and market frequently aren’t aligned.
Where the Fed and market disagree
“There's been basic tension between what the Fed says and what the market believes for some time,” said Mike Kraft, Commercial Real Estate Treasurer for Commercial Banking at JPMorgan Chase.
“The Fed has made it clear: Their No. 1 job is to contain inflation, and their intent is to keep the short-term rate high for as long as it takes to do so,” he said. “The Fed’s messaging indicates it could hold interest rates at the current level, or even higher, through 2023.”
“The market generally anticipates a pause for a meeting or two, although some look for a hop, skip or jump where the Fed raises interest rates at a subsequent meeting,” Kraft said.
What interest-rate hikes mean for multifamily investors
While the odds of a recession are up in the air, the possibility looms large over commercial real estate.
“Higher borrowing costs combined with concerns of an economic slowdown have been headwinds to commercial real estate,” said Ginger Chambless, Head of Research for Commercial Banking at JPMorgan Chase. “However, underlying fundamentals vary greatly by segment.”
Demand for multifamily properties remains elevated due to the tight housing supply and high mortgage rates, which have made home purchases more expensive.
- Industrial real estate is experiencing tailwinds related to domestic manufacturing capacity and infrastructure investments to meet customers’ on-demand expectations.
- Retail performance has been mixed, depending on location and concept.
- Office faces challenges due to changes in working patterns, including remote and hybrid work.
Typically, interest rates decrease in a recessionary environment. How quickly rates drop and to what degree depends on how high inflation is running and the severity of an economic slowdown.
Lower interest rates could benefit commercial real estate values in the long term. “But in the near term, values could be hurt by a pull back in business and consumer spending activity,” Chambless said.
Hedging interest rates
Amid economic uncertainty, real estate investors may consider hedging options. Before you decide to hedge against interest rates, you should:
- Understand your business’s cash flow
- Assess the interest rate sensitivity of your revenues and expense
Economic factors influencing interest rates
While interest rates have a unique influence on commercial real estate, it’s important to look at multiple economic factors, including:
- Labor markets: Tight labor markets have driven wage growth and job security—two key factors for consumer spending. “Consumer spending drives nearly two-thirds of U.S. gross domestic product (GDP) on an annual basis and has shown resilience despite the higher interest rate environment,” Chambless said. If labor market conditions weaken, consumers may reduce their spending.
- Inflation: “Inflation has been running at multi-decade highs for almost two years, and it remains well above the Fed’s 2% target—a key data point in today’s market environment,” Chambless said. If inflation doesn’t continue to track toward 2%, we could see the Fed resume interest rate hikes later this year.
- Treasury yields: Treasury yields can impact hybrid- and fixed-rate loan pricing for commercial real estate investments. The 10-year Treasury yield in particular helps determine mortgage rates and can be a sign of investors’ economic sentiment. Rising yields may reflect higher levels of expected inflation in the long term, while falling yields could indicate lower inflation and a possible slowdown or recession.
It’s also important to consider factors specific to commercial real estate, such as location, asset class and cap rates, as well as demographic shifts and supply and demand.
An economic downturn could have a significant impact on commercial real estate. Find out how multifamily investors can prepare.
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