Those who follow finance news probably noticed that, on last Wednesday, the news broke that 13 out of 18 members of the Federal Open Market Committee believe that the Fed will increase interest rates at least once, and perhaps twice, in 2023.
Needless to say, the news shook up equities markets. Stock prices fell and treasury bond yields increased.
While the market has more or less calmed down, we can’t help but notice that this keeps happening. Let’s break down what’s going on, and what it could mean for real estate investors.
Are rates going up sooner than expected?
Hard maybe. Two quick notes before we dive into the analysis:
- We’ve written before about Fed policy and commercial interest rates. While the Fed can deploy a variety of tools to influence commercial rates, it does not unilaterally set them; commercial rates generally hover 1-2% above 10T yields, which the Fed does control the supply of, but plenty of other forces can also influence commercial rates.
- While commercial interest rates impact real estate — in large part because real estate investors use leverage to enhance returns — the real estate business isn’t necessarily bound to follow the Fed’s every fluctuation. Compared to real estate, traditional equities markets are fairly volatile, in part because they’re fairly liquid in comparison — the stock market might adjust for undetermined possible future monetary policy, but the real estate market just isn’t as susceptible to those short-term market shocks.
With that said, it’s pretty difficult to say on the basis of what happened last week whether any real change is pending at the Fed. For starters, there’s a few good reasons to think the news is overhyped and rates may not, in fact, increase in 2023:
- 13 out of 18 Committee members isn’t a guarantee. Powell is still largely in control, and if he isn’t among the 13 who suspect rates will increase (and, based on his comments for most of the past year, it seems unlikely that he is), there’s little reason to believe the Fed will try to raise rates.
- Supposing Powell is on board with elevating 2023 rates — on the presumption of uniform economic progression between now and then — a rate increase is nonetheless not assured. 18 months is a long time (see: 2020). While the bull market that’s defined much of 2021 has investors equal parts excited for the future and concerned about an impending correction, there’s no guarantee that inflationary conditions will persist into 2023. It’s a long way from now, and any number of unforeseeable events could modify the situation enough to convince the Fed to reverse course.
- Perhaps the most likely reason to think inflation may not run uncontained for the remainder of 2021 and 2022 is that there’s been (warranted) speculation about a market correction for some time.
We know this is a somewhat contrarian take. But, finance journalists’ business is to project the possible future implications of what we know now, and one consequence of being in the prophecy business is that most prophecies turn out to be incomplete. For now, we’re holding our horses.
It’s also worth asking: “under what circumstances would the Fed try to increase rates?”
In the context of the last 18 months, the answer is mostly: “inflation.” Inflation has, indeed, occurred; just look at the consumer price index. But, we also want to point out that, in an inflationary environment, commercial rates are likely to increase organically, even without interference from the Fed, and that could conceivably happen before 2023.
Where does that leave us?
Rates may or may not increase. (Sound familiar?)
If rates do increase, real estate investors could be looking at a handful of implications, which we’ve written about before. Quick summary:
- The cost of capital increases. Leveraging new projects costs more as rates increase, and over the long run, investors will have to offset increased costs by capturing economic growth through rent increases.
- Cap rates increase. In the short run, that could mean strong returns; however, rising interest rates signal an environment in which investors are less willing to offer a premium to acquire investment assets, which could dampen velocity.
- Finally, consumers access greater liquidity in an inflationary economy. Inflation often increases demand, and implies that the market can tolerate rent increases.
The bottom line
Trying to play the markets by guessing about future events subject to a panoply of difficult-to-know causal influences is, realistically, really hard. For some skilled traders, it works. For many others, it doesn’t.
Real estate investors are operating on a different set of considerations. While rising interest rates can offer both advantages and disadvantages for real estate investors, fortunately, real estate as an asset class is historically a strong hedge against the inflationary environments that could lead to rate increases.
Why is that?
Real estate investors can secure strong returns despite increasing rates, because mortgages last longer than leases. In an inflationary economy, your mortgage payment stays the same while rents increase.