What does the U.S. interest rate hike mean for real estate?

On March 15, the U.S. Federal Reserve raised its overnight funds rate by 25 basis points, taking it to a target range of 0.75 percent to one percent. The move was widely-anticipated given the strengthening economic backdrop, with recent figures showing U.S. unemployment dipping to 4.7 percent, inflation at 2.7 percent, business investment firming, and the Fed forecasting growth of 2.1 percent this year.

Markets now expect rates to climb steadily, fueled in part by the prospect of heavy spending on infrastructure and defense, coupled with tax cuts and higher inflation. The Fed has indicated there will likely be two more hikes during 2017, taking the funds rate to between 1.5 percent and 1.75 percent by year-end. The next move is expected in June, with another in December.

Limited impact on real estate … for now

The shift towards monetary policy normalization has been a long time coming. The March rate increase was only the third since the financial crisis, following single small hikes in 2015 and 2016. But the pace is picking up, with the most recent move happening just three months after the last.

For the real estate sector, this latest rate hike alone should not be too disruptive, says Ryan Severino, JLL’s Chief Economist in the United States. “The upside is that it is a signal of the economy’s strength, which could be a harbinger for improvements in fundamentals.”

For instance, the brightening economic climate could bode well for several commercial real estate sectors, including the office market. More rapid future economic growth should spur further corporate expansions, helping fill office inventories.

“The downside,  notes Severino, “is that over time, as rate hikes continue, the cost of debt will become increasingly expensive, which could affect investor sentiment, pricing, and volume.”

Susceptible sectors

While 2016 saw some activity declines across a range of sectors, asset pricing remained broadly stable. However, with interest rates rising, concerns over current pricing levels, and a shifting liquidity landscape, pricing is under pressure. Signs of plateauing or softening cap rates are already evident in parts of the hotels, office and multifamily sectors.

Going forward, those property types that have experienced, and should continue to experience, robust construction volumes – such as apartments, industrial and hotels – will likely be most impacted in the near term by rate rises.

“That is not just because higher interest rates could increase the cost of construction and development loans, but because these property types are pretty far along in the cycle,” explains Severino. “Investors might become a little more circumspect if they see markets at or near peak, construction volumes high, and interest rates rising.

Investor considerations

In the short run, one rate increase is unlikely to have much impact on investors. If rates continue to climb though, the rising cost of debt service payments may squeeze cash flows, especially for highly-leveraged investors.

“This will likely produce a shift away from more leveraged investors towards investors that utilize more equity,” says Severino.

Offshore investment activity levels may also be affected if there is a further strengthening in the U.S. Dollar. Last year saw the second highest level of acquisitions by offshore investors in recent history, with the hotels and office sectors particular targets. Investors from Asia, Europe and the Middle East were all active sources of inbound capital, as each region ramped up relative U.S. deal flow in 2016.

But with many central banks around the world maintaining extraordinarily low rates and loose monetary policies, in recent months the U.S. Dollar has hit a 13-year high against other global currencies.

“If rate increases lead to a further dollar appreciation, it could make the environment more challenging for foreign investors,” notes Severino. “Lately though, we have seen the dollar weakening versus world currencies, as the fortunes of the global economy start to look a little brighter.”

Meanwhile, rising bond yields may begin to alter the relative value proposition for investors of fixed income instruments versus cash flow-producing real estate, notes Severino. “But we will have to see what happens to net operating income growth and yields as the year progresses.”

Future outlook

With two (and possibly more) U.S. interest rate hikes in the offing for 2017, and potentially more in the years to come, we can expect growing upward pressure on real estate cap rates.

“If fundamentals continue to improve, there shouldn’t be much movement in cap rates,” says Severino. “However, if fundamental growth slows down, then we could start to see more pronounced cap rate increases over time.”

By: Ryan Severino, Chief Economist, JLL, March 31, 2017. A link to the original article can be found here.