Don't Look Now, But Interest Rates Look Likely To Keep Rising All Year
The yield for the 10-year Treasury note hit a 12-month high of 1.64% on March 12, having taken less than three months to increase by more than 70 basis points since the start of this year. Though a 10-year Treasury benchmark rate below 2% is still very low by historical standards, a newly optimistic outlook for the U.S. economy and an impending influx of stimulus checks make further increases a near-certainty.
Since the 10-year Treasury yield is used to set interest rates on many forms of long-term debt, an increase in that number generally corresponds to new loans being more expensive to pay back. Although the commercial real estate industry has historically dreaded rising interest rates, that doesn’t necessarily mean an upward trajectory for Treasury bonds is an ominous sign in the current environment.
“There’s a conventional wisdom that rising interest rates are categorically bad for real estate; that’s not necessarily true,” JLL Chief Economist Ryan Severino said. “If interest rates are increasing because the economy is accelerating, then real estate improves because cash flow increases, cap rates come down. You can still find pockets of disruption, but as long as the economy is doing well, commercial real estate performance should be pretty good.”
Despite that confidence, when early signs of weakness prompted rate cuts from U.S. Federal Reserve Chairman Jerome Powell in 2019, there was a sigh of relief from the real estate industry and predictions that premature increases would wreak havoc.
A common refrain among those operating in the commercial real estate debt market is that even if interest rates keep rising, they have a long way to go before they become prohibitive to securing new financing. Many even doubt that the 10-year benchmark will ever reach a rate that would have been considered high in the 20th century.
“You’ve got structural issues with people living longer, working longer and saving more,” Arden Group Chairman and CEO Craig Spencer said during Bisnow’s Deal Flow and Investment Strategies digital summit this month. “There are so many things globally that have created this supply of liquidity that I don’t see changing, and most people I know don’t see it changing. So we all think [interest rates] are going to stay low for a long, long time.”
Owners of leveraged real estate assets were cognizant of the unprecedented trough that the Treasury yield was in last year and refinanced as many loans as they could to lock in such rates long-term before they started rising again, multiple experts told Bisnow. But that option was only available for borrowers and assets that gave lenders confidence in being repaid long-term.
For struggling borrowers in workout discussions with lenders, floating-rate loans are a more common method of refinancing or getting new debt, and such short-term options respond more to other benchmarks, such as Libor, over the 10-year Treasury yield. Libor has remained low over the past few months with little indication of an imminent increase, DBRS Morningstar Senior Vice President of North American CMBS Edward Dittmer and Silver Eagle Advisory Group founding partner Ed Adler agreed.
Where the discussion may change is in the market for distressed assets, as investors looking to take on debt to buy struggling malls or hotels may be getting squeezed before the market sees the anticipated year-end influx of deals. Because of the abundance of liquidity, it seems a certainty that distressed asset deals will see a lot more competition than they did in the early days of recovery after the Great Financial Crisis.
More competition means higher prices and/or lower cap rates, exacerbating the effects of higher interest rates, Nuveen Managing Director Jason Hernandez said at the Bisnow digital summit. Wandering into less crowded territory in search of more yield to offset those rates runs the risk of playing in a part of the market that won’t necessarily join in the recovery.
“Because the spreads are wider for some of the sectors where we’re a lot more reserved in our projections, you can more easily absorb the impact of higher rates,” said Sam Chandan, New York University's Larry & Klara Silverstein Chair of Real Estate Development & Investment and the dean of its Schack Institute of Real Estate. “Even so, I expect those will be the sectors that suffer the greatest impact in the short- to medium-term because of our more conservative outlook for those property types.”
A crucial part of the U.S. economic story in 2021 will be how many of the jobs return that disappeared nearly overnight when the initial outbreak occurred. As of the end of February, the U.S. still has 9.5 million fewer jobs in the market than it did a year previously, according to the U.S. Bureau of Labor Statistics.
If the newest round of economic stimulus increases consumer spending but doesn’t meaningfully improve the job market for unskilled and service industry labor, that could cause a spike in inflation, sending more people scrambling to buy up Treasury bonds and accelerating the increase in interest rates beyond what the commercial real estate industry can absorb, Chandan and Severino agreed, although both considered that scenario to be unlikely.
Even aside from its relationship to the 10-year Treasury yield, employment will be a much more important number for those in commercial real estate to track, Dittmer said.
“This late in the recession, people are still losing jobs,” Dittmer said. “And in real estate, that’s what I’m worried about — how many people are going back to work, and how many businesses are opening up … In this cycle, we’ve had many more businesses close down. So as the economy starts to grow, the businesses that would bring people back aren’t there anymore.”