No Surprise as Fed Raises Key Interest Rate, but Hike Still Sends Shiver Through REIT Sector

By Randyl Drummer; Courtesy of CoStar

December 14, 2016

While commercial real estate analysts and investors have anticipated an increase in the Federal Reserve’s key short-term interest rate for several months, baked-in expectations failed to prevent a sell off of stocks in REITs and the broader market when Fed Chairman Janet Yellen finally announced a rate hike on Wednesday.

The central bank’s Federal Open Market Committee not only announced only its first increase in the federal funds rate since December 2015, raising the short-term benchmark rate by 0.25% to a range of 0.50% and 0.75%, with Fed officials pointed to a strengthening labor market nearing full employment and inflation that’s moving more rapidly toward targeted levels.

At the same time, the Fed indicated it will likely raise the rate at least three more times over the coming year as robust job growth and the economic expansion continue followed the surprise election of Donald Trump. The Dow Jones Industrial Average fell 0.6% Wednesday in the rate-related sell off falling short after a record run that has come tantalizingly close to the 20,000 point mark in the record market run in the weeks following President-Elect Donald Trump’s surprise victory Nov. 8. The FTSE NAREIT Equity REITs index, meanwhile, took at 2.29% hit, closing at 635.32 on Wednesday.

As U.S. Treasury yields have increased, REITs have sold off since their September peak. Total returns for the FTSE/NAREIT All REIT Index dropped 2% in November, compared with a 3.7% gain for the S&P 500 as the Trump rally kicked into high gear. Equity REITs fared even worse, with the FTSE/NAREIT All Equity Index falling 2.4% last month.

As the expected Fed move approached, Morgan Stanley on Monday lowered its outlook for the REIT industry from ‘in-line’ to ‘cautious’ in recognition of the dual impacts of rising rates and slowing growth, which have caused REIT multiples to contract. However, unlike previous REIT share sell offs that have presented buying opportunities for investors, Hill and his team this time advises against doubling down on the sector.

The year started off as if it would be another banner year for the sector, but trusts have significantly underperformed in the second half of 2016, Hill noted, adding that even as earnings growth is likely to be slower than anticipated for the year, rates have risen faster than expected.

Unlike past sell-offs when interest rate hikes were accompanied by accelerating fundamentals, occupancy and rents are peaking just as rates rise, causing revenue growth to decelerate, noted Morgan Stanley REIT analyst Richard Hill. “The market has priced in higher rates, but underappreciates slowing growth and therefore REIT multiples have room to contract,” Hill said.

Most CRE professionals surveyed by CoStar on Wednesday confirmed that the market was expecting this interest rate bump and expects the effect on property markets to be minimal, at least for now. “Most of my clients say aren’t going to be a negative impact on their operations from the rate hike,” said Anthony La Malfa, assurance partner in BDO’s real estate, construction and hospitality division. “The impact will really be on the value side of the property. Where values have been increasing fairly strongly, the spreads on capitalization rates are probably going to need to be higher with the rate hike, which will drive down valuation a bit.”

“Rates can’t stay at zero forever,” added colleague Brent Horak, assurance partner in BDO’s real estate and construction practice. “Over the last couple of months, people have come to the realization that rates are going up and that it will probably affect values, and stock prices are taking the toll. Now the question is how high rates will go and what will the President-Elect’s policies do?”

Ken McCarthy, principal economist with Cushman & Wakefield, noted that the 25-basis-point increase in the federal funds rate and the indication by the Fed that three more increases are likely in 2017 is a reflection of the continuing health of the U.S. economy. Unemployment is low and job growth, an important driver of demand for office space, is still solid, and higher wages and income are expected to boost consumer demand and hence demand for retail and industrial space, McCarthy added. “Overall, the Fed’s move is a vote of confidence in the current state of the economy and the real estate outlook,” McCarthy said.

Peter Hauspurg, chairman and CEO of Eastern Consolidated, opined that “I think we’ve seen the end of the dramatic rise in asset values that began in 2010 and reached 2% per month for many years.”

Matthew E. Sullivan, managing director and partner at Orlando, FL-based CRE advisor Cite Partners, said that while borrowing costs will increase some, “we don’t anticipate a negative effect. From what we’re seeing, the investment sale market continues to remain strong with plenty of capital chasing deals, which should keep cap rates steady,” Sullivan said.

A couple of observer were more sanguine about the Fed move, particularly its plan for multiple stepped increased over the next 12 months.

Today’s increase will have little to no impact on CRE, however, future increases “will impact investor and REIT returns, and that will trickle down, especially if the federal funds rate rises above 1.25%, suggests Del Markward, president-elect of the Society of Industrial and Office Realtors (SIOR) and president of Allantown, PA-based Markward Group. “If interest rates continue to rise down the path that the Central Bank projects, then capitalization rate will rise and put downward pressure on real estate values,” added Robert S. Nelson, president of Nelson Management Group.

The multifamily investment sector could feel the increase most acutely. Residential mortgages will likely become more expensive in an environment of rising interest rates, putting homeownership further out of reach and a clear advantage for apartment landlords, according to Kevin Finkel, executive vice president with Philadelphia-based Resource Real Estate. “The Fed’s actions today is a sign of a strengthening economy, which means people will likely have more cash, which could place landlords in a strong position to raise rents,” Finkel said.

From an investment perspective, apartments are a good hedge against the Fed’s warning about inflation risk because leases renew every 12 months, as opposed to office and industrial leases that renew every few years, positioning owners to capitalize on inflation by increasing rents, Finkel added. The Fed action will also increase apartment financing costs, making it even more difficult for developers to finance new apartment construction, Finkel noted. “Rising rates will only continue to make obtaining construction loans more costly and continue to put a cap on new apartment construction, limiting new supply,” he said.