When the Economy Says Jump, How High Will Interest Rates Go?

Anticipating where interest rates are headed seems as difficult as almost any intellectual undertaking that one could mention.

Integra Realty Resources took a stab at looking ahead to an answer in a new commercial real estate trends report because interest rates are a lynchpin to how anything in the commercial real estate industry works.

First, the yield curve — yields on shorter-term Treasuries compared to longer-term ones — inverted in 2022. Short-term yields were higher than long terms. This has historically been a reliable indicator of upcoming recessions.

“That said, interest rate risk for private-market assets — including residential and commercial real estate — has features beyond yields in the Treasury space,” they wrote. “Indeed, we see some worrisome elements in the cost of capital for such private market assets. Economists have a fancy word, ‘inelasticity,’ for the propensity of market interest rates to be ‘sticky,’ or to change with a lag to Treasuries and to adjust only partially to moves in the risk-free Treasury rate.”

So how do the private-market and public monetary strategies interact? It’s not so clear because it isn’t a simple mathematical relationship, but a psychological one.

There were extremely low rates coming out of the General Financial Crisis or Great Recession, pick the name that seems best, all with an eye to stimulating the economy for more than a decade. “And just as the economy became healthy enough to withdraw such supports, the Covid-19 pandemic hit and the Fed needed to return its policy rates back toward the ‘zero bound.’” Indeed.

At this point, they argue, that even if inflation comes back down to a roughly 2% on average over time, chances are low that interest rates will return to pre-pandemic, or pre-inflationary run-up, rates.

“Only in the case of another global catastrophe – economic, political, environmental, or public health – would rates return to the level persisting for the past decade or so,” they said. “That’s not a ‘normal’, new or otherwise, to be expected.”

IRR notes that in a “sustainable inflationary world,” Treasury notes should be between 300 and 350 basis points above consumer inflation. “Private market rates should require a further premium of 250 — 400 basis points, depending on the risk profile of the assets.”

“For well-underwritten home mortgages, that suggests rates above 6% through the middle of this decade,” they said. “For commercial properties with reasonable leverage, this would imply cap rates centering on 7% – 7.5%, depending on location and property type.”