Booming Economy Prompting Hawkish Fed Policy

June 13 the Fed raised its benchmark interest rate, the Fed Funds rate, by another ¼%. Two additional increases anticipated in Sept and Dec. The Fed’s overnight lending rate is now in a range of 1.75% to 2.00%. Citing stronger consumer spending, and a highly optimistic business community, the Fed laid out the potential for two additional rate hikes in 2018. The Fed noted strong job growth, accommodative fiscal policy and above-target inflation as reasons for continuing to normalize monetary policy over the coming months.

Lending interest rates have increased in this rising rate climate. By and large, benchmark loan rates have followed, particularly on loans maturing in the 5-7 yr. time-frame, and bridge loans which typically max. out their term at 3 yrs. While some lenders are absorbing a portion of the increase, borrowers will increasingly face higher interest rates, which may motivate CRE buyers to seek price reductions. However, economic growth continues to lift NOIs, prompting sellers to remain committed to higher asking prices, creating an expectation gap. Net-leased properties face the greatest rebalancing risk due to their bond-like lower yields, but they have yet to undergo sympathetic repricing.

Much talk has emerged lately regarding the flattening yield curve and its implications for a recession. This is usually referenced by the compression spread of 1 yr. vs. 10 yr. Treasuries, now in the 30-40 bp range. The mechanics here is that the short end (duration) of the market follows along with Fed increases with a tight correlation, while the long end doesn’t. Longer term bond buyers are effectively saying that they believe the Fed’s rate increase will short-circuit the economic expansion and implied accompanied inflation, and force the Fed to do a 180 and decrease rates to stave off an economic collapse.

For investment CRE this materializes in CAP rates. CAPs have historically taken their lead from the 10 yr. Treasury – what is now considered a long-term rate. Since the 10-yr. rate has held its ground vs. the Fed’s increase, CAP rates haven’t had much of a response to the rate increases. And consequently, prices of the underlying properties have largely held firm. Individual property and investment considerations that will color this generality are the asset class of the property, the quality of the lease and hence the tenant, and in-place financing that may be assumable. Of course there’s more, but for the most part the CRE investment arena has stood firm in the face of rising interest rates, notwithstanding lender behavior on your loan of choice.

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Michael Green is a Commercial Loan Originator for the Counsel Mortgage Group®, LLC.

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