The most recent 25 basis point rate cut to the federal funds target rate wasn’t enough to keep the yield curve from inverting. The markets weren’t happy with the modest cut and more rate cuts are expected (some predict as many as 3 more cuts by year end).
The gut reaction for any commercial real estate investor is likely positive. A lower cost of capital means more cash in your pocket, right? However, when you think about cutting rates in an environment where strong underlying market fundamentals already exist (e.g. low unemployment , wage growth), it doesn’t leave a whole lot of room for additional easing should the economy slow some more, and additional boosts are needed.
In my opinion, it was too soon to ease monetary policy, at least in terms of the health of the commercial real estate industry. Both domestic and foreign institutional investors are attracted by the yields that commercial real estate can deliver. And, these investors possess an enormous supply of undeployed capital ready to be invested. As a result, demand remains high for U.S. investment properties.
In fact, demand has so outstripped supply in this mature market cycle that both foreign and domestic institutional equity investors are increasing their investments in secondary and tertiary markets. Real estate investment firms today are aggressively investing beyond the normal big market city markets (like Boston) to secondary and tertiary markets (like Worcester and its nearby communities) in search of real estate that offers a good going-in basis and the opportunity to add value through their investment and expertise.
These secondary and tertiary markets, however, are way more sensitive to large market swings given their baseline with lower rents and higher vacancies compared to primary markets. Should there be a disruption in corporate profits demand for real estate will dissipate. After all, the cash-on-cash returns are only available when the underlying demand and credit of the tenancy is stable.
In this type of recessionary scenario, the near term sugar high of rate cuts this fall will surely be eclipsed by the dramatic retreat when the market corrects. For real estate investors, the key to surviving such a recession – however mild or severe it may be – will be to keep leverage optimized while building in sensitivity to your projections. Assuming banks will likely retreat from offering long-term on balance sheet rates, if you have a long-term investment horizon, now is the time to lock in with a long-term rate with your bank.
Meg Liddy is Senior Vice President of Capital markets at Kelleher & Sadowsky. She specializes in Debt Placement. She can be reached at [email protected], or 508-635-6797.