Well, it has finally happened. Last month, in a unanimous vote the board of the US Federal Reserve voted to raise interest rates one quarter of a percentage point. Although hovering at historic lows, during the near term additional interest rate increases are anticipated to slowly occur as the Fed continues its stance supporting further improvement in labor market conditions and a targeted return to an inflation rate of 2%.
When the cost of debt increases, theoretically capitalization rates follow suit, and if income remains flat, mathematically property values decline. The reality though is that commercial real estate does not march to the beat of just one drum, and the correlation between capitalization and treasury rates is tenuous. Timing and other variables influence the bond and real estate markets very differently. Other key variables that influence capitalization rate movements include credit availability, demand and supply dynamics and inflation.
Large pools of yield chasing domestic and foreign capital allocated to US commercial real estate have yet to be deployed, and the Fed move will have little if any impact on most markets. Current spreads between going-in commercial real estate returns and competitive investment vehicles including bonds, stocks and treasuries is very wide, resulting in significantly more room for interest rates to rise before upward pressure on capitalization rates occurs. With this said, certain markets and/or property types may be more susceptible than others to interest rate increases.
The Fed chose to increase rates because the economy, most notably employment is growing. Rising economies create an increase in demand for real estate, which in turn puts upward pressure on rental rates. Essentially, increasing interest rates in tandem with higher incomes generally results in a wash.
Finally, given that growth outside the U.S. is very low, and the value of the dollar is considerably high, over the short term the Fed is unlikely to dramatically raise interest rates. Rising interest rates would make American exports less competitive while foreign markets’ demand for American goods declines. Interest rate increases in the current environment reflect the anticipated strengthening of US economic and employment conditions which bodes well for commercial real estate, including, notably, hotels.