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On December 16, 2015, the Federal Reserve decided to raise the target range for the federal funds rate 1/4 to 1/2 percent OR about 0.25%, the first increase in over eight years.
Federal Reserve also intends to reduce its balance sheet soon.
Have you ever wondered what all this means and how it is done?
Federal Reserve uses two basic mechanisms to set interest rates: Interest on Excess Reserves and Overnight Reverse Repurchase Agreements.
In this article, I intend to discuss the above mechanisms and what it means for commercial real estate asset prices.
I am not an interest rate strategist or an economist, but I am generally curious about interest rate policy as it has an effect on all asset types, including commercial real estate (CRE). The purpose of writing this article is to understand and explain in simple terms the mechanics of how interest rates are set in the current regime and what impact the process is expected to have on CRE asset prices.
There are two big determinants of CRE pricing: net cash flow (NCF) and interest rates. In most simple terms, the value of a CRE asset (whether a public REIT or a private asset) is the present value of NCF discounted at a discount rate. The discount rate is the sum of a base rate (which I consider is the then prevailing interest rate on longer duration U.S. Treasuries) and a spread that reflects the credit risk of the asset (Discount Rate = Base Rate + Risk Spread). The typical reaction to CRE asset prices whenever there is chatter about raising rates is that prices will fall. This reaction is more pronounced in the public REIT markets versus private assets and this creates very attractive opportunities in the public REIT space from time to time and investors should take advantage of the same.
In this article I try to cover the base interest rate aspect of CRE pricing and what it means when the Federal Reserve comes out and says that they will increase rates and/or reduce their balance sheet. In doing so, I do not intend to provide any statistical analysis of the correlation between cap rates and interest rates, but rather use simple examples that are easy to grasp to prove my point.
By no means does this article cover all the nuances of how interest rates are set. I welcome if there are any interest rate strategists on this forum to comment on the below and provide a better understanding.
Contributed by Gene Powers, President, Nationwide Secured Capital nationwidesecuredcapital.com
