By Alex Rhoten
Low interest rates for the past 12 years sent the Commercial Real Estate industry on a whirlwind decade of double-digit growth.
When interest rates are low, the economy is strong and the cost of borrowing money decreases. This is an investment opportunity.
In March, the U.S. went into an economic tailspin due to the coronavirus pandemic that swept the entire world into bear markets. The Federal Reserve Bank made two emergency rate cuts in response. America’s central bank has the duty of keeping the economy safe and stable.
After 12 years of a low fed rate of two percent or less, to see it near zero, the lowest it can go, may be a once-in-a-lifetime event. Low interest rates should continue to provide momentum and stability for commercial real estate in 2020.
A cautionary tale of inflation
Many still remember 1979 and 1980.
During a time of high inflation, the fed rate peaked at 20 percent. Believe me, the ghost stories of the early 1980s are a cautionary tale of what could happen again. As of April 20, 2020, the federal funds rate was just.05 percent, effectively zero. Remembering the high interest rates of the early Reagan years, this current 0 to.25 percent fed target rate is a dream world. However, very low rates spur economic growth, and when growth is excessive, that causes inflation.
How Fed rates affect commercial real estate
A healthy economy has a two to five percent fed rate. During times of inflation, the fed raises the rate to try to slow the escalation. Since 1990, inflation and interest rates have been low and stable. Cap rates move closely with both of those variables and cap rates affect asset value. Although home mortgages are more closely aligned with 10-year Treasury yields than the fed rate, the variables of commercial real estate as income property are a bit different.
A loan with a very low interest rate has the nickname cheap money because it doesn’t cost much to borrow. When the fed lowers its rate, the cost of money is lower for banks to borrow from other banks and this gets passed on to investors/borrowers. Although lower interest rates tend to push down capitalization rates (the cap rate formula is Net Operating Income/Current Market Value), other factors affect cap rates, too.
Cap rates in turn are used to determine an asset’s value. The relationship isn’t as direct as some would say; nevertheless, cap rates and real interest rates do tend to be in lockstep with each other over time. When the fed rate rises again, and it will, this will drive up the price of commercial properties because higher interest means spending more to borrow, and that cuts into profits.
Here and now
Stable interest rates for 2020 and a predictable market with consistent cap rates are great for commercial real estate investors. With a fed rate near zero, make hay while the sun shines.
Alex Rhoten is the owner and Principal Broker at Coldwell Banker Commercial Mountain West Real Estate.