How the Fed’s Response to Inflation could Create Headwinds for CRE

How the Federal Reserve responds to inflation could create headwinds for the commercial real estate market, particularly as the Fed walks back earlier efforts to keep the pandemic-era economy in motion.

“Inflation is not the enemy of commercial real estate,” says John Chang, senior vice president and director of research services at Marcus & Millichap. “In fact, inflation can help investors boost their cash flow and property valuations.”

But there’s always a but, Chang says: while the Fed typically targets inflation in the 2% range, it currently sits at between 5 and 7%.

And “the Fed doesn’t like inflation that high,” he says. “They’re trying to curb inflation by tightening the money supply.”

Chang notes that since the onset of the pandemic, the Fed has poured about $4.5 trillion into the US economy through programs like quantitative easing, doubling their balance sheet. At the same time, the Fed dropped the overnight rate to 0% to keep short term interest rates down.

“They were basically juicing the system so we didn’t drop into a pandemic-induced recession,” Chang says. “Don’t forget, we lost over 22 million jobs in just a couple of months at the onset of the pandemic, but now they need to walk the money supply back and raise rates to curb inflation.”

Chang says the Fed may even start selling off Treasuries to push rates up, and notes that the Fed has indicated they will soon raise the overnight rate.

“This is where a potential risk for CRE shows up,” Chang says.  “Elevated capital liquidity is creating an aggressive commercial real estate bid climate that’s putting upward pressure on prices and downward pressure on commercial real estate yields, their cap rates.”

Depending on property type and location, cap rates are running as low as 2.5%. Because most investors take out a loan when they buy a property, they generally want the interest rate to be below the cap rate. As the Fed pushes rates up, the spread between the cost of capital and the property yield tightens.

“If rates rise only or 50 or 100 basis points, it probably won’t be much of an issue, but if the Fed has to hit rates hard to get inflation under control, that could create a challenge for commercial real estate sales,” Chang says. And a significant rise of interest rates – think a couple hundred basis points or something similar—could be sufficient to slow activity and put upward pressure on cap rates.

“There are a lot of variables in play and I’m not saying the sky’s about to fall, but investors need to keep a close eye on how the Fed manages the interest rate climate…investors even thinking about taking chips off the table might want to get a broker opinion of value just to see what the potential looks like,” Chang says.

Source: Globe St.