Commercial Real Estate Forecast After The Fed Tightens

Investment real estate has been generally appreciating in this environment of expanding economic activity and low interest rates, but what will happen when the Fed tightens?  Commercial investors should be fine for the first and second year of Fed tightening. After that, look for sluggish returns.

Real estate investment trust prices have dipped the last few months, probably on expectations of rising interest rates on commercial mortgages. On the positive side, total returns for investment real estate, which include both operating earnings and price appreciation, have averaged 13 percent over the past four quarters, based on the properties surveyed by National Council of Real Estate Fiduciaries.

Office vacancies continue to decline gradually, as do retail vacancies. Loan default rates on such properties continue to be low. Hotels are doing well, with average revenue per room up by 6.4 percent in the past year.

In short, this current environment of moderate economic growth (excluding the first quarter) and low interest rates has been positive for commercial real estate investors. The graduated improvement in vacancy has delayed new projects, so competition is not too strong.

However, the Federal Reserve is hardly an evil pixie. The Fed will raise interest rates only when they see further strength in the overall economy. That strength in the economy will boost occupancy and rents, improving operating earnings. In the early stages of Fed tightening, the stronger economy dominates. In two years or so, the slowdown in the economy combines with the higher discount rates to hurt commercial real estate.

Although the Fed can peg short-term interest rates, such as the one-year treasury, it has less control over longer-term interest rates. The 10-year bond, for example, is driven more by global demand for credit and supply of savings than by Fed policy. Thus, it may not be Fed policy that pushes up commercial mortgage rates.

Commercial investors will most likely see good total returns in the next two years, but it’s worth considering what could go wrong. International recession, originating in Europe or China, could trigger a downturn in the United States, ruining occupancy and rents in 2016. Looking farther ahead, if the Fed’s tightening proves to be too much, too soon, then a recession would begin in 2017, most likely. Thus, the positive returns that are the best forecast right now are not guaranteed. And if you didn’t know that already, you have no business investing in real estate.