The Fed's Increase in Interest Rates and Its Impact on Commercial Real Estate
• As expected, the Fed raised the fed funds rate by 25 bps today
• Market mostly priced in this result, so near-term volatility is muted
• Further increases are expected in 2016 and beyond
• UK rates are likely to follow in 2016 H2 but ECB rates will stay on hold until 2019
• Long rates will start to drift up across Europe but the increase will be sooner and steeper in the UK than in the Euro area.
• London prime yields are likely to have bottomed out but there is still room for further yield compression in continental European and regional UK markets.
• There will not be a one-for-one relationship between changes in long-term interest rates and property yields – currents spreads ae wide enough to provide a cushion which will prevent this happening.
The US Perspective by Spencer Levy, Head of Research – Americas, CBRE
The Federal Open Market Committee (FOMC) raised interest rates today for the first time since 2006. The 25-basis-point (bps) increase to the target federal funds rate was all but a forgone conclusion for anyone following financial news in the last few weeks. Wall Street was hardly caught off guard; interest rate futures placed a better than 75% probability of this result since the release of the strong October jobs report. The strong November jobs report, in particular the first evidence of wage inflation (the other "I" word) in some time, sealed it.
Some characterized today's move with phrases such as "pulling the trigger" or "lift-off," but the reality is much less explosive. The initial rate hike is just another baby step in a long haul toward conventional monetary policy. While we expect these baby steps of 25-bps incremental increase to continue through the next year, the Fed will only do so in a U.S. economy that continues to improve and a world or black swan event doesn't throw a monkey wrench into the path of the tip-toeing baby. The beauty of Janet Yellen's data-dependent credo is that it allows the Fed to adapt to ebbs and flows in the economy. You will almost certainly not see a repeat of the last tightening cycle in which the Fed raised rates at 17 consecutive meetings.
Despite the big news of today's move, the Fed has stealthily been in tightening mode since ending its asset purchases in October 2014. A shift toward more hawkish communication has altered the public discourse to focus on the mechanics, timing and pace of interest rate increases. The Fed's consistent communication about future policy—referred to by Ben Bernanke in his recent book The Courage to Act as "Open Mouth Operations"—is a de facto rate hike in itself and dampens the real impact of today’s announcement.
Reading the tea leaves of the next Fed move is more complex than ever now that financial market health and global growth play a more prominent role. The U.S. may still be the biggest kid in the school yard, but it has a lot of other major global players to deal with and the Fed is more sensitive to global activities than ever. Not the least of these worries is the health of China, followed by the health of emerging markets that have borrowed heavily in US dollars and may not face additional stress if the US dollar strengthens further.
The bottom line is that the Fed is raising rates because the domestic economy is doing well. Things may get tricky as the expansionary cycle runs its course and interest rates near equilibrium, but that’s still a few years away.
The European Perspective by Dr. Neil Blake, Head of Research – EMEA, CBRE
Today’s announcement by the Fed will not have an immediate impact on short-term interest rates in Europe. The Bank of England’s Monetary Policy Committee members are still making generally dove-ish noises about interest rates with only a solitary dissenter and the ECB is currently running a zero-to-negative interest rate policy – something that is unlikely to change in the near future. This does not mean, however, that what happens in the US today will not impact on Europe tomorrow.
Mark Carney, Governor of the Bank of England, is always at pains to stress that UK monetary policy is independent and that what happens in the US does not necessarily have any bearing on what happens in the UK, The reality, however, is different. Whatever the official view, the Bank of England has not been keen on taking the lead on interest rate normalization. There are a number of reasons for this but a big one is the potential impact on the value of sterling. Sterling has held its value against the dollar and has appreciated against the euro and other currencies. This in itself is already starting to have adverse impacts on UK manufacturing and an interest rate hike in advance of the US would have made the situation worse. The implication is that now that the Fed has moved, an increase from the Bank of England is all but inevitable unless events force the Fed to reverse their decision before the Bank moves. This does not mean that UK interest rates will move immediately. Our view is that they will begin to increase in 2016 but the increase might not be until the second half. As with the US, any increase is likely to be the start of a normalization process not a one off and we anticipate that UK Bank rate will increase gradually, events permitting, in quarter point steps reaching 2% by the end of 2019.
The situation in the Euro area is rather different to that in the USA and UK. The economic recovery in the Eurozone, although now well underway, is lagging behind that in the UK and USA and, significantly, quantitative easing was only introduced earlier this year. The ECB’s overnight deposit rate is actually negative and its main refinancing rate is only 0.05%. This is unlikely to change while the QE policy is in place and this, more than likely, puts any increase back to 2019.
All of the above refers to short-term policy rates. What actually matters to commercial real estate are long-term rates both because long-rates affect the cost of finance for investors and because they represent a relatively risk-free rate on an alternative investment. What happens to expectations of future moves in policy rates, not just where policy rates are now, are the major determinant of long-term interest rates. To some extent, long rates have already “priced in” the expectation of today’s increase in US rates and the potential impact on European rates but the very fact that they have gone up will harden expectations of future increases both in the UK and, eventually, in the Eurozone. The likely consequence is that long rates will still drift up from now on and, as with short rates, the increases are likely to be slow and gradual but we expect that UK long rates (the yield on 10-year Treasuries) will reach 3 5% by the end of 2019 (up from 0.95% on Tuesday) and that the German equivalent will pass 2% by the end of 2019 (up from 0.66% on Tuesday).
Sooner or later this will mean high yields for commercial property but how fast this happens will depend on the type and location of the property. In general the spread between property yields and long rates is sufficiently wide to provide a cushion which will mean that property yields will not move one-for-one with long-term interest rates. In other words, property yields may appear to be very low but, in relative pricing terms, investors have actually displayed some caution and have “priced in” some expectation of future interest rate increases.
The expected sharper increase in UK long rates means that the impact will be felt sooner in the London market than in other European gateway cities. In fact, in many continental European markets, yields are likely to fall further in 2016 as investors clamour for greater Euro area exposure. Regional markets in the UK are also likely to be less affected initially by rising rates as an increasing expectation of rental growth offsets the rate increase. In these markets, sudden yield increases are very unlikely unless there is a threat of a renewed economic recession and this is not seen as likely at present (notwithstanding the black swan events mentioned above).
Finally a word on the euro. QE and low interest rates in the Eurozone have sent the euro plunging against the dollar. This actually appears to have contributed to increased investor demand in the Eurozone as overseas investors have gambled on a future exchange rate gain as and when the euro recovers. Higher US interest rates may not send the euro down any further as the increase is already likely to be “priced in” but it will help to keep the euro low in the short-term, keep downwards pressure on yields and this bodes well for investment in the euro area in 2016.
