A Fed Rate Hike Reverberates Through the Capital Stack for Months

There’s an interesting misconception in CRE, even among those practiced in it, though likely not before the global financial crisis. It’s this: the Federal Reserve raises interest rates and financing for commercial real estate immediately feels the impact.

And that is true, there is an immediate impact. “The effects of Fed rate hikes are felt very quickly in commercial real estate, or any highly leveraged industry, for that matter,” as Kevin Swill, CEO of Thirty Capital Financial, tells GlobeSt.com. “If you think we need to wait six months to see the effects of rate hikes, you’re not following the volume of caps we see very closely. Ask any borrower that needs to refi a loan or buy a springing cap how long it takes for rate hikes to hurt.”

“The June increase of 75 basis points was the biggest single increase in rates in nearly three decades, and at its July meeting, the Fed matched that increase for the second time—its fourth increase this year,” says Dianne Crocker, principal analyst at LightBox. “The higher costs of capital are forcing commercial real estate professionals to adjust to a new landscape and the need to reevaluate their market positions and adjust expectations.”

However, the immediate result isn’t the only one. Implications reverberate for months.

“Statistically, we know that U.S. real estate pricing and transaction volumes lag changes in interest rates and the financial markets by 9 to12 months,” Avison Young principal and global chief economist Nick Axford tells GlobeSt.com. He notes that the 10-year BBB corporate bond, which is the bottom end of investment grade, “correlates very well with real estate cap rates with a 12-month lag.”

The reason? Although there is that original impact given the degree to which CRE uses relatively high leverage, the full effect of changes takes time. “Thus, the impacts of the first rate rises earlier this year are really only now becoming evident in the statistics, although we are seeing clear evidence in the flow and pricing of deals currently in negotiation,” Axford adds.

There is also a difference in the type of data and where and when it becomes available that creates a difference in outlook. “It is really important in understanding who you’re asking,” says Omar Eltorai, director of research at Altus Group. “A lot of the economists and when you’re looking at it from a high level, you’re looking at data that is aggregated and is more lagged.”

And, when conditions are changing rapidly and significantly, as with Fed policies currently, time gaps and lags matter everywhere. “Even though you’ve locked in a rate, you may not have closed in yet,” Eltorai adds. Loans currently closing may reflect the past, so what the market seems to suggest as going rates may already be outdated. That alone is a two- to three-month gap.

Now add the secondary effects that extend beyond the direct impact on CRE. Businesses and consumers face the longer implications of rate hikes six months down the line and not just today. That affects what both can and are willing to spend, how negotiations go, whether companies develop financial problems, and how that can translate into late rent payments and escalating vacancies.