CRE Can Withstand A Higher Rate Environment. Here’s Why

Fed Chairman Jerome Powell has apparently ruled out more aggressive rate hikes in the future following a 50 basis point increase Wednesday, saying at a press conference that anything higher than that is “not something we’re actively considering.” 

“A 75-basis-point increase is not something we’re actively considering,” Powell said at the presser, as reported by CNBC. “I would say I think we have a good chance to have a soft or softish landing, or outcome if you will.”

Speculation abounded after the last Fed meeting as to whether rates would tick up by more than 25 basis points. A review of the March meeting minutes also suggested decreasing the Fed balance sheet by up to a proposed limit of $95 billion per month through the natural maturation of Treasuries and mortgage-backed securities.

Despite that hand-wringing, the expected rate trajectory is still below historical levels, according to research from Marcus & Millichap. The firm’s researchers note that at the apex of the last real estate cycle in 2005 and 2006, the commercial property market was “clicking away” with a Fed Funds rate as high as 5.3% and a 10-year Treasury rate as high as 5.23%, below the average 10-year Treasury rate of 6.07% that’s been observed over the last five decades.

“While the Fed Funds rate has hovered around zero for more than a decade, the planned Fed hikes will still keep interest rates at relative historical lows,” analysts note in a new report. “It may have an impact on a market that has seen cap rates compress and construction costs rise, due to a low interest rate environment. Despite this, history demonstrates it is possible to have a strong commercial real estate market in a higher rate environment than many currently contemplate.”

Fed policy also appears to be emphasizing existing debt, with “aggressively steep” future rate projections leading to higher interest rate cap costs and high swap spreads. Initial feedback from securitizations that began after last March’s rate hike is that spreads are “nearly even, despite a greatly increased base index rate.”

“If this trend continues, interest rates will move back toward the mean, and that makes assumable debt that originated over the past few years incredibly valuable and accretive to the next buyer,” the report states. “Some of the sub-debt that was raised during the pandemic might finally find a home in acquisitions of assets stacked on top of assumable debt, as the blended cost of capital may be cheaper than a full leverage permanent loan in the coming years.”

Marcus & Millichap does note that interest rates are not likely to come down anytime soon, but reiterates that they’re still at “historic low.”

“Rate locks at application and forward rate locks are becoming a more important consideration than rate or leverage for many. This makes life company debt a much more attractive option than risking a major retrade, prior to closing a CMBS execution,” the firm notes. “One of the bright spots of the recent rate hike is a decreased defeasance cost for loans that are currently securitized. More owners may consider refinancing loans that are a year or two from maturity, paying the reduced defeasance cost, and recasting the loan for more term at what are still historically low rates.”

Meanwhile, rates remain appealing for transitional assets, but Marcus & Millichap advisors say it still makes sense to ink deals now,  “before the risk of cap rate decompression and debt yield expansion plague higher-proceed alternatives.”