For the recovery in commercial real estate investment, and for the policy makers that have worried over the systemic implications of mass mortgage defaults, historically low interest rates have proven one of the downturn’s few blessings. The last few quarters’ sharp rise in property sales, in New York City and other major markets, would have been impossible under a scenario of significantly higher rates.
Similarly, in the management of legacy distress, loan extension and modification strategies have depended inordinately on lowering borrowers’ interest costs. As a result, the principal write-downs that could undermine the viability of many lenders have been relatively few in number.
While a rise in interest rates is inevitable, a sharp increase over the next year could upset the commercial real estate market’s return to health. If baseline measures of debt capital costs climb, property values, borrowing costs and lenders’ loss-mitigation strategies would each have to adjust in ways that would temper current investment trends.
The question of higher rates is not academic. Rather, it has returned to the fore in recent months, as long-dated treasuries have fallen in price and yields have risen from their nadir in October. The 10-year treasury rate has risen by almost 100 basis points over the past three months. Although many economists attribute the increase to the slowly improving economic outlook, the offset may be in higher borrowing costs that would dampen the outlook.
Thus far, commercial lending rates have resisted upward pressure from rising long-term treasuries. Improving sentiment with regard to the commercial property outlook currently dominates any such headwinds.
But in a forewarning of potential challenges for commercial property markets, residential mortgage rates have been rising over the past few months. From an extraordinary low of just under 4.2 percent in November, Freddie Mac reports that average 30-year fixed mortgage rates have inched up to nearly 4.8 percent as of last week, down from closer to 4.9 percent a week earlier. Given the fragile state of the residential recovery, even marginally higher rates are unwelcome.
Short-Term Rates and the Policy Bias
What then is the outlook for interest rates? Short-term market rates are expected to remain at extremely low levels for some time. The London Interbank Offered Rate (LIBOR), in particular, is virtually unchanged since last September, hovering near historic lows across the range of 1-month to 12-month terms.
With substantial slack in the real economy and few indications of upward pressure on core prices or labor costs, monetary policy makers have enjoyed their full degree of discretion in maintaining an accommodative policy bias for short-term rates. This bias will likely persist.
In its most recent revision, the Fed’s staff’s economic outlook anticipates that core personal-consumption-expenditure price inflation will trend lower in 2011 and 2012 than previously projected, even as energy costs rise. Supported by this benign outlook for inflationary pressures and mindful of its full employment mandate, the Federal Open Market Committee elected in December, with one dissension, to maintain the 0 to .25 percent target range for the Federal Funds Rate. Signaling its intentions for future meetings, the committee restated “its expectation that economic conditions are likely to warrant exceptionally low levels for the federal funds rate for an extended period.”
Private forecasters are evenly split between expectations of further weakness in the economic recovery, resulting in an unchanged target rate in 2011, and, in the alternative scenario, projections that the target rate will rise as high as 1 percent by year end. The most current economic data seems to support the former scenario.
The December jobs report, for example, shows that employers remain extremely reluctant to grow payrolls. While the unemployment rate fell to its lowest level in 19 months in December, the rate of net new job creation is agonizingly slow. As it stands, there are 7.2 million fewer jobs in the United States than at the peak of the market, in December 2007. At the current pace of job creation, it would take just under six years-until late 2016-for employers to replace those jobs. To encourage an improvement in labor market outcomes, monetary policy makers are obliged to remain accommodative in the absence of offsetting inflationary pressures.
For the time being, there is little chance of an increase in short-term rates related to the Fed Funds target. In fact, if the target rate had not already reached its lower bound, the FOMC might reduce it further. Chairman Bernanke, in testimony before the Senate Committee on the Budget last week, stated as much in explaining why the Fed has turned to less traditional forms of market intervention: “In a situation in which unemployment is high and expected to remain so and inflation is unusually low, the FOMC would normally respond by reducing its target for the federal funds rate. However, the Federal Reserve’s target for the federal funds rate has been close to zero since December 2008, leaving essentially no scope for further reductions.”
Long-Term Interest Rate Outlook
Unlike the short-term target rate, long-term rates are subject to the vagaries of a market over which the Fed exerts more limited and less direct influence. It is in this arena that the most serious risks present themselves. Yields on long-dated government bonds will rise in correspondence with the economic outlook, responding to favorable policy developments such as the extension of tax cuts. This is the most manageable circumstance involving higher rates, because it also implies that property fundamentals are generally improving.
But rates can rise for other reasons as well. Apart from an improving economic outlook, an increase in expected inflation will positively impact treasury rates, as will an increase in treasury issuance or an increase in investor risk tolerance.
Why might rates resist rising, or even fall back? For one, expectations of slow growth and modest inflation keep treasury rates low. Rates also narrow as a function of risk aversion. As investors’ appetite for risk wanes or market risk increases, the risk-free investment becomes relatively more attractive, pushing prices up and driving yields lower. The risk-averse character of investors has been a factor in pushing treasury rates lower as the European sovereign debt crisis has unfolded, driving investment into the safety of U.S. government assets.
Will an improving economic outlook trump instability in Europe, pushing rates higher? For now, the outlook for long-term interest rates is fairly manageable. In December’s Wall Street Journal Economic Forecasting Survey, the overwhelming majority of participants projected that rates would remain at or below 4 percent through the end of 2011. Only a small subset anticipates that rates will rise to about 5 percent. For rates to rise above 5 percent in 2011, the economy or capital markets would have to experience some unexpected shock.
For Now, a Benign Interest Rate Outlook
Unless growth or inflation expectations are revised upward, or demand for treasuries slips unexpectedly, investors and lenders should anticipate that rates will remain low by historic standards. Modest increases in long rates are unlikely to be unsettling to commercial real estate markets; it is only at the upper bound of the forecast range for long-dated treasuries that pressures on cap rates and comparable-term lending rates are likely to become apparent.
Still, we cannot afford to be complacent. In spite of the baseline expectations, there is an element of unpredictability in this market that is exaggerated by
our current fiscal position, among other factors. Thomas Hoenig, president of the Federal Reserve Bank of Kansas City and the dissenting voter at each of the last eight meetings of the FOMC, pointed out in a commentary last week that “the reaction of interest rates and exchange rates to unsustainable fiscal policy can be sharp and disruptive.”
This presents us with a problem since, as Chairman Bernanke reaffirmed last week before the Senate, “It is widely understood that the federal government is on an unsustainable fiscal path. Yet, as a nation, we have done little to address this critical threat to our economy.”
Sam Chandan, Ph.D., is global chief economist and executive vice president of Real Capital Analytics and an adjunct professor of real estate at Wharton.