How will any Federal Reserve action impact the cost of capital and cap rates? Jonathan Hipp takes a closer look in this EXCLUSIVE column on the subject.
In March 2019, the Federal Reserve announced it would leave the key interest rate unchanged, bringing to a halt the hikes it had begun in late 2015. In the same announcement, the Fed forecasted one rate hike in 2020, and stated they will stop reducing their bond portfolio by fall 2019. The Fed opted to take a hands-off approach to the federal funds rate, due to a forecasted slowdown in the global economy.
Any Federal Reserve action brings the inevitable question from the CRE community, namely, how the action will impact the cost of capital and cap rates. Halting rate increases and reducing their bond portfolio are intended to keep cost of capital low. In July 2018, we outlined the theoretical parallel relationship between interest rates and cap rates; when the former goes down, so does the latter.
Breaking this down, federal funds rate increases can lead to higher interest rates, increasing the cost of capital. The higher cost of capital will limit the pool of properties an investor could purchase. The limited number of investors and increased cost of borrowing will put downward pressure on property values, leading to higher cap rates.
That’s the theory. Now, here is the reality.
There is more to property values and cap rates than just interest rates. Capital supply is equally as important. Investors need lenders who are willing to underwrite deals and loan money. Today, there is a large amount of capital chasing a limited deal supply. This is why the Fed has boosted the federal funds rate nine times since late 2015, and cap rates haven’t followed.
In fact, according to NAREIT, cap rates narrowed in 2017-2018. An increase in rents has led to higher property values. The situation is in direct contrast to what happened prior to the 2007-2009 financial crisis. At that time, increasing property values were driven by market perception, rather than increasing income flows or improving real estate fundamentals.
To conclude, it’s important to keep an eye on what the Fed is doing. However, it’s just as important not to be overly concerned about interest rate movements and their possible impact on cap rates. In fact, net lease investors and brokers are better off examining capital availability, income flow, and property values, rather than worrying about the current federal funds rate.
The views expressed here are the author’s own and not that of ALM’s real estate media group.