What does the Fed Rate Decrease Mean for Commercial Real Estate?
Arash Sotoodehnia, PhD
On Wednesday July 31st, Jerome Powell, Fed Chairman, announced a 0.25% decrease in the Fed Funds target range to 2.0%-2.25%, the first decrease in the Fed’s main policy rate in over a decade. It was a turning point, and an acknowledgement by the Fed that the trade war with China is having a real impact on the American Economy. However, the magnitude of the rate reduction disappointed both (i) the market, immediately post announcement, the market had fell by 1.1%, and (ii) President Trump, who tweeted his displeasure after the meeting. The market and the President were disappointed by both the size and in the Chairman’s characterization that this was a mid-cycle adjustment to policy and not a signal for a sustained period of interest rate reductions to stimulate the economy.
In the month since the July 31st meeting, the yield curve has inverted, with the 3-month treasury bill rate above the 10-year rate over an extended period, and even the two year rate above the 10-year rate for several days over that period. Similar rate inversions in the past have preceded recessions. The Fed is conflicted in that it is not yet certain if the head winds caused by trade friction with China and potentially with Europe will depress economic growth sufficiently to require further adjustment to their rate path.
The President’s Trade Action
The trade war, and the President’s pronouncement on August 23rd that American Firms “should leave China”, have significantly ratcheted up the uncertainty associated with doing business with China. American firms may have to figure out a way to undo 30-years of investment and relationship building with their Chinese counterparts, or they may not, depending on how the trade war concludes.
This uncertainty has reduced business investment, with business investment slumping by 5.5% in Q2 of 2019. Industrial output and manufacturing have both begun to contract. It is expected that business investment will go down further, as will manufacturing activity, providing a significant drag to Q3 GDP figures. While consumer spending was solid in Q2, the uncertainty is beginning to impact measures of consumer confidence and will likely depress Q3 GDP figures below those of Q2.
The Fed futures market is now pricing in a near certainty that the Fed will again reduce the Fed Funds rate on their September 18th meeting by 25 bps, and the market is pricing in a better than 50% probability of a third 25bps point cut in rates before the year is out. (See chart above regarding market expectations based on Fed Funds Futures as of September 3, 2019) We expect that the 10-year treasury rates will continue to drift down, and that the ten year will be below 1.5% for an extended period in the 4th quarter.
The question is, “how all this will impact commercial real estate?” Prior to the trade tensions, and after the tax cuts took effect, the market expected a fed funds rate closer to 3%, with an overheating US economy, and GDP growth coming close to 3% for the year. The rise in rates would likely have pushed cap rates up from their historically low points, with property values being supported by robust NOI growth, offset by rising cap rates. However, with the change in outlook, I expect less pressure on cap rates. Unfortunately, as the economy softens, I expect less NOI growth, with overall CRE prices remaining stable throughout the 4th quarter. I also expect some of the trends that we have observed over the past few years to continue or be reinforced by the impact of the trade tension and slowing economy. The President provided a recent reprieve to tariff increases that would have raised prices on many consumer goods imports from China to December 15, reducing impact on retail sales until after the critical holiday period. However, after the tariff increase on these goods goes into effect in mid December, retail sales will be impacted, putting additional pressure on the retail CRE sector. Facilities that support services should be impacted less than stores selling consumer goods, nevertheless, the expectation is of continued pressure on the CRE retail segment, with particular pressure on traditional malls and consumer goods stores. In the CRE retail sector we expect cap rates to go up, and NOI’s to go down, pushing CRE retail values down.
I expect that the administration’s trade stance will begin to push American supply chains out of China and into South-East Asia, Mexico, and to a lesser extent back into the US. The costs associated with this shift, and the disruption of existing business relationships by large American multinationals in China will reduce the profitability of large multinational firms, putting pressure on their hiring and therefore pressure on Class A office demand in large metros, resulting in some softening of Class A office property prices. However, insourcing some manufacturing back into the US and Mexico will likely result in an increased demand for Class B and C light industrial and warehouse space, especially near the Mexican border, and in traditional manufacturing centers like the inland empire in southern California, and the US Midwest. We expect these types of CRE property types to hold their value and to be good CRE investments as the trade war plays out.
In summary, if the trade war continues, the 4th quarter will prove to be an inflection point for the American economy and for Commercial Real Estate. Interest rates will remain low, with the ten year treasury likely spending the quarter at or below 1.5%. We expect the impact of the coming slow down to be focused mainly in consumer goods retail outlets, and CRE Class A office space, with other commercial real estate sector values remaining stable on a national basis, with some local variation.
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