Don’t Expect A CRE Windfall From Interest Rate Cut

U.S. Federal Reserve Chairman Jerome Powell indicated in early July the central bank could soon cut interest rates for the first time in more than a decade. While commercial real estate typically welcomes rate cuts, economists don’t think it will drastically alter the industry’s growth trajectory.

The U.S. economy remains in a good place, but it has weak spots. A prolonged trade war with China, a slowdown in manufacturing, economic uncertainty abroad and inflation below the Fed’s 2% target rate are giving the central bank reason to consider lowering interest rates to combat tepid growth. 

Lower rates could give a confidence boost to some developers on the fence about moving forward with a project so late in the current economic cycle, but Spencer Levy, CBRE's chairman of Americas research and senior economic adviser, said the industry has already accounted for a future rate cut. 

The real economic movement would happen if the Fed didn’t lower rates. 

“What does a Fed rate cut mean for commercial real estate? Steady as she goes, that’s what it means,” Levy said. “If we don’t see one, there will be a fall in business consumer sentiment, which will negatively impact the industry.”

The industry expected the Fed to continue with interest rate increases at the beginning of the year, but weak manufacturing data in May coupled with concerns of economic instability caused the Fed board to recalibrate. Most commercial real estate industry experts have now factored in at least one interest rate drop in 2019 with respect to pricing, and many expect a second decrease by year’s end, Levy said. 

“If it doesn’t happen, you’re likely to see a dramatic negative reaction from the market because that is not anticipated,” he said.

The stock market has already responded favorably to the expectation of a rate drop. Major indices like the Dow Jones Industrial Average, the S&P 500 and Nasdaq are up an average of nearly 2.5% for July, particularly bolstered at the end of last week following Powell’s remarks that a rate cut was likely. 

But while Wall Street numbers hit historic highs — the Dow closed above 27,000 for the first time in its history following Powell’s rate cut comment — another economist isn’t convinced real estate is going to respond in lockstep. 

“What we’ve seen over the recent regime of interest rates is the metrics for CRE have been sticky relative to interest rate changes,” said Hugh Kelly, a special adviser at Fordham University and a primary author of the Counselors of Real Estate’s "Top Ten Issues Affecting Real Estate." “This isn’t to say it doesn’t have an effect. I just don’t expect real estate to have a knee-jerk reaction.”

The expected limited initial reaction is partially a sign of the times with how commercial real estate has operated in recent years. 

Most developers have grown accustomed to the low interest rate environment that was put in place following the 2008 recession and has persisted since, Kelly said. The last downturn was triggered in part because what worked in the low interest rate environment of the early 2000s couldn’t withstand rate increases leading up to the recession. 

The bright spot of today is that developers aren’t as highly leveraged as they were during the last period of economic growth. Kelly estimates loan-to-value and loan-to-cost ratios have dropped on average by about 20%.

But, he cautions, while developers may have priced in rate drops, they haven’t priced in long-term anemic growth. 

“I don’t think this industry and economy in general has seen the onset of a cycle with the expectation that when you come out of a downturn, you’ll be at 30-40% of growth you were at in the previous expansion,” Kelly said. “That’s where we’re at.”

Despite the robust economy and fact that the current economic cycle is the longest period of expansion in U.S. history, economists recognize it is a fragile recovery. 

Only 39% of Americans have enough money to handle an unexpected financial hit, according to Bankrate. The Congressional Budget Office issued a report in January forecasting sub-2% growth in gross domestic product, down from 3.1% in 2018, beginning next year through 2029, driven in part by business investments declining after ramping up around passage of the 2017 tax reform. 

“I don’t think any markets, equity or real estate, have priced in that radical reduction of final demand,” Kelly said. “We’re in for a shock when that becomes apparent.”

Others in CRE still expect short-term fixes to get deals across the starting line as a result of future interest rate drops. 

The yield curve between 10-year U.S. Treasury notes and three-month Treasury bills briefly inverted twice this spring before settling into its current, prolonged inversion since May 22. Although not always a sign of downturn, an inverted yield curve has signaled the last seven U.S. recessions. 

Institute of Real Estate Management President Don Wilkerson said lower interest rates have the potential to take pressure off the bond markets and take the yield curve out of its inverted state. 

“From a real estate standpoint, you’re in the longest period of recovery, so people start to think defensively in the natural cycle of things,” Wilkerson said. “By lowering rates, those decisions that were defensive go away and you stimulate the CRE market.”

The Fed’s move could generate a rally toward Treasury bonds, which is how many multifamily projects are financed. Rates will be more attractive and developers on the fence would want to lock in longer-term financing or even refinance at the new rate. 

But even Wilkerson doesn’t expect a prolonged positive shift in real estate development from the potential rate cut. 

“It helps developer and commercial real estate confidence that we have a little bit more time to play before we’re looking at another recession,” he said.