Don't Hold Your Breath For The Fed's Rate Cuts To Boost The Real Estate Market
The U.S. Federal Reserve is trying to extend the economy’s lengthy growth cycle by cutting interest rates, but the commercial real estate market appears to be greeting it with a shrug.
“The rates don't matter,” Mack-Cali Realty CEO Michael DeMarco said.
Historically, the Fed has lowered short-term interest rates in times of economic contraction as a way to stimulate growth. But softness in overseas markets and volatility caused by the trade war between the U.S. and China has prompted Fed Chairman Jerome Powell to take proactive measures to preserve stability, he has publicly acknowledged.
The rate cuts are intended to encourage investors to pump capital into the economy. But in the week since the Fed announced its second cut, real estate stocks have not seen a boost, The Real Deal reports. Commercial real estate experts say the cuts are unlikely to spur more deals, either.
“My guess is that a lot of investors thought, ‘Ho-hum, 25 basis points,’" JLL Chief Economist Ryan Severino told Bisnow. “That was the expectation, and that might have been baked into the price already.”
The two 25-basis point cuts this year have brought the short-term interest rate down to around 2%, and had been hinted at for months. Mack-Cali, a New Jersey REIT that owns and develops apartments and offices, had already factored in a second cut into its strategy by the time the first was announced in July.
The Fed's attempts to goose spending in an economy where the stock market and real estate prices are at or near all-time highs aren't likely to push them into some imagined higher tier, according to Severino and DeMarco.
“Rates are already on the very lowest end,” DeMarco said. "They could keep cutting it, I guess, but it wouldn’t matter.”
“It’s not fully understood at the moment by economists, but ... there seems to be quite a lot of money in the world sloshing around and not as much interest in investing,” Barkham said.
The lack of enthusiasm seems to be at a fundamental level that an incremental discount to borrowing can't address.
“Cutting rates doesn’t make trade tensions go away, make the U.S. and China play nicer,” Severino said. “It doesn’t do anything to affect the global slowdown in markets.”
Memories of the last recession have kept the real estate industry from getting too aggressive with leverage during this cycle. Multiple debt brokers and lenders have told Bisnow in recent months that they have not shifted their leverage thresholds despite the interest rate environment seemingly encouraging them to do so.
“This cycle has been much less debt-driven than previous cycles,” Barkham said. “Excess equity capital is going into the real estate sector, and there’s not enough deals. Debt might be cheaper, but people don’t use it as much because they don’t need it as much.”
Whether the cuts are able to juice the investment market or not, they are likely to have one impact: The Fed may be foreclosing on the possibility of short- and long-term interest rates increasing for years at least, the economists said.
“I think we face a period of super-low interest rates for at least five, if not up to 10 years,” Barkham said.
When it comes to real estate borrowing, the short-term interest rate doesn't have quite so much impact as the yield rate for the 10-year Treasury bond, Severino and Barkham said. Sold at auction rather than at a set rate, the 10-year bond's yield goes down as prices rise in times of low investor confidence, since they are fully guaranteed by the Fed.
The 10-year yield sat at 1.70% on Sept. 26, and has been lower than the three-month yield all month; the so-called "inversion" between the two rates has historically been a predictor for recessions. If 10-year bonds are in greater demand than three-month treasury bills, that is likely because investors think the economy will be in worse shape in the near term than 10 years out.
Independent of cyclical activity, those 10-year rates have been in decline since the early 1980s, and this period of nearly 40 years where long-term debt has become less expensive over the course of loan terms has provided a buffer for projects that missed return goals, Severino said.
“I’m not saying that you haven’t had really smart people in the real estate industry, but [10-year] interest rates have structurally come down, which has been a huge tailwind for our interests,” Severino said. “If the rates on debt are trending downward over time, it has probably papered over mistakes people have made because they haven’t been punished severely.”
While the margin for error has been wide, the upside on commercial real estate deals has steadily decreased. Through the 1980s and 1990s, CRE could have been reasonably expected to deliver 9% returns; now, that number is down to 5% or 6%, Barkham said.
If interest rates are approaching a trough that they have been sinking into for decades, then the real estate market would be losing a safety net that it has become accustomed to.
Still, at least some real estate investors are proceeding with faith that the tide will turn again.
“Everyone always assumes rates come up; it’s part of the business,” DeMarco said.
An economy where rates remain low through the entire life of a growth cycle would mean that the business DeMarco has been a part of for years is undergoing a fundamental change. If that is the case, the Fed cutting rates now may do more harm that good.
Trying to stimulate an already-growing economy with lowered interest rates could result in a more severe downturn when the cycle does shift, Boston Federal Reserve head Eric Rosengren said in a statement explaining his dissent to the rate cuts. Encouraging borrowing by making debt cheaper could lead to borrowers making riskier bets with that debt, according to multiple dissenters on the Fed Board of Governors and multiple economists, including Severino.
A common belief among economists is that a recession can be a necessary, if painful, part of the economic circle of life, like a wildfire clearing portions of a forest so new growth can have the room to take hold.
Though the dot-com bubble bursting two decades ago brought devastation to the office market, “a lot of good came out of it,” Barkham said.
Attempts by the Fed at the time to forestall the dot-com collapse may have intensified its effects, Severino said.
Private equity could be the wild card in the current environment, as the relative lack of regulation can result in fund managers promising higher returns for their investors and chasing those returns aggressively — leading to the risk-taking that concerns some on the Board of Governors.
If private equity capital can't find satisfactory returns on straight property deals, it has occasionally responded by pumping capital into real estate-adjacent technology companies or startups.
The ready availability of investment capital may discourage some companies from going public for longer, Severino said. Much like the way extending a cycle past its natural life could lead to a harder downfall, remaining private for longer may lead to a harsher reality check.
“I’m not sure that the private value assigned to those companies would hold up if they were publicly traded,” Severino said, declining to name any specific examples. “That has the potential to push valuation for private companies in a way that is different from cycles past.”
SoftBank Vision Fund's uber-aggressive investment into WeWork drove the coworking unicorn's valuation to a level that collapsed under the scrutiny of a forthcoming IPO, which could raise concerns about other privately funded real estate companies. The private equity issue is likely more pronounced in the tech market than in real estate, Severino said, but the line between tech and real estate gets more blurry every day.
While WeWork's size made it an outlier, the environment that has driven trillions of dollars into private equity in the past decade is the same that the Fed wishes to preserve for at least the time being. But a small rate cut or two won't be the cure for all ills.
“You might be able to delay the end of the economic cycle, but if it was that magical, then cutting interest rates would be like magic pixie dust for the economy,” Severino said.