Since cutting short-term rates to near zero in March of 2020, the Federal Reserve has been clear about the prospect of interest rate increases: they don’t intend to raise them any time soon. Fed Chair Jerome Powell released a statement in September, promising near-zero interest rates until 2022 or 2023, nominally to protect a pandemic-ravaged economy. The stated intent is clear.
On the other hand, a new president, the beginning of vaccine roll-outs, and the increasingly likely prospect of stimulus may complicate things as the year goes on. Inflation is not thought of as a primary economic concern in the near-term because of the Fed’s stated intent to keep rates low, but as the economy potentially roars back to life, perhaps it’s not entirely unthinkable that inflation could actually loom on the horizon. This piece is a thought exercise to help us understand what might contribute to that unlikely event.
Real estate investors should be asking two questions:
- Will the Fed’s rates increase?
- Will rates increase on my projects?
This analysis will help you think through those questions.
The State of Play
As of mid-Q1, the economy is in better shape than it was during most of last year. While GDP fell over 3% in 2020, it’s projected to rise by nearly the same amount, if not more, in 2021. Similarly, the unemployment rate — while still roughly twice what it was a year ago — has fallen more than 50% since its peak in April. It’s still not great, but it could suggest a recovering economy.
Those indicators are good signs, but they don’t mean that the recession is in the rear view mirror. Unemployment is still up, GDP is still down, and the jobs recovery has slowed. Markets look strong: the Dow and S&P 500 are now hovering above where they began January 2020, but 2020 clearly demonstrated that the market is not the economy. Stock prices don’t tell the full story (GameStop is our teacher), and if corporations hold onto cash instead of investing in hiring and production, economic growth will remain lethargic.
Regardless of frothy asset valuations, the Fed has remained publicly committed to preserving the status quo of rock-bottom rates until the actual economy is healthy.
Is The Status Quo Viable?
This is the 27-trillion-dollar question. Historically, near-zero interest rates have been, at best, viable positions for short-term disaster recovery. Near-zero or negative interest rates (the latter have seen prominent use in Japan, but the Fed has shown reluctance to choose that path for the US) have fared worse over the long term.
Near-zero interest rates render an economy susceptible to what Keynes termed liquidity traps. Low rates encourage spending and increase the velocity of money by expanding loan availability. Favorable financing terms suggest more consumer purchasing, but low rates are a double-edged sword. Acquiring a loan may be cheap, but financing one isn’t profitable for lenders and investors. The disincentive to invest creates a liquidity trap: low rates fail to stimulate growth, because the public prefers to hold money in the expectation of increasing rates in the future. In other words, low or negative rates might end up driving money into mattresses, which isn’t good for the economy and could lead to further stagnation. In that scenario, rates definitely are not going up any time soon.
So, How Could Rates Go Up?
One possibility is that the economic recovery proceeds far more quickly than anticipated, without significant assistance from economic policy. While that scenario is unlikely to materialize prior to 2022, it’s possible — and could mean higher interest rates later this year.
A more likely outcome is that the economy continues to struggle, and the federal government may see the solution to a potential liquidity trap in switching emphasis from monetary to fiscal policy. Monetary policy is primarily under the management of the Federal Reserve, whereas fiscal policy is dictated by government legislation. In this instance, a government administration that favors stimulus could be decisive. “If decreasing rates did not stimulate enough growth,” or so the reasoning goes, “maybe increasing the money supply would?”
Additional stimulus could have two consequences. On one hand, it could succeed where monetary policy hasn’t, and jumpstart employment and production back to pre-2020 levels. On the other hand, it could fail to save the economy from an impending liquidity trap wherein the money goes under the mattress. In either case, the elephant in the room is the COVID timeline, and the real indicators of an economic comeback might not be stimulus packages but case numbers and the vaccine rollout.
These are formidable uncertainties, and waiting for the Fed to reverse course on monetary policy while they continue to unfold is a bit like watching paint dry. While the Fed has indicated a preference to keep rates low well into 2023, there are at least two plausible scenarios in which they rise sooner.
In this scenario, rampant spending — $1.9 trillion on top of last year’s nearly $4 trillion stimulus — requires the Fed to help underwrite a large deficit. This could potentially result in the Fed selling bonds, which contracts the money supply -- and money costs more when there's less of it. Depending on how the Fed answers a large budget deficit, stimulus could raise rates single-handedly.
In this scenario, the stimulus works, the economy recovers quickly, and rampant growth triggers Fed controls designed to keep a lid on inflation. This is a concern the Fed has publicly acknowledged. Depending on the rate of inflation, the Fed may taper off bond-buying programs to ensure the money supply doesn’t expand too far. In this scenario, interest rates will likely rise slowly as the Fed retreats from its interventionary stance.
There’s no certainty here. Additional stimulus isn't guaranteed, and plenty of unanswered questions surround continued vaccine roll-out logistics and other COVID-related concerns. The true timeline for putting the pandemic in the rear-view remains unclear. If congressional deadlock, logistical hurdles, and emerging viral strains continue to create significant uncertainties, they could suppress economic recovery enough to contain inflation through the rest of 2021 and beyond.
What Does This Mean for Real Estate?
Fed Funds likely won’t move materially anytime in the next few months. But, the overnight rate isn’t the only driver for commercial rates, and there’s debate to be had over whether the Fed leads the market, or follows it.
This is where 10-year Treasury Yields come in. Bond yield is positively correlated with bond supply, and yield rates are climbing (probably under the expectation of increased supply following elevated federal spending). Because the yield rate for government bonds is effectively the risk-free floor for lenders and investors, rises in 10Ts — which usually hover 1-2% below commercial rates — could incline lenders to price in rising bond yields and raise their rates. This is especially consequential for the real estate sector, because fixed-mortgage rates typically follow treasury yields. Whether or not the Fed is the first mover, commercial rates could very well increase in an environment where the 10-year treasury is climbing.
That’s why we’re keeping our eyes on the yield curve, and preparing for a possible rate increase this year. If rates do rise, real estate investors will be looking at three major implications.
First, the cost of capital increases. Leveraging new projects will require more expenditure as interest increases and payments rise. Without a corresponding rent increase, that could cause problems for investor returns. Locking in favorable rates early could help mitigate the increase, but over the long run, augmenting cash flows by capturing economic growth through rent increases will be important.
Second, interest rates are correlated with cap rates. High cap rates may be welcome in the short-term for investors looking to forge new deals, but the algebra works both ways: high cap rates might mean strong returns (although the conversion from cap rate to cash-on-cash depends heavily on the lending environment), but they also mean lower property values when it’s time to exit. Rising interest rates signal an economy in which investors are less prepared to offer a premium to acquire investment assets. That reality can potentially complicate exit strategies for existing real estate funds. In some markets, this means rising cap rates can put a significant damper on velocity; if your holdings are suddenly worth less, why sell them now? While there are sellers in every market, the "sell/hold" decision is often a marginal one, and upward pressure on cap rates would likely act as an additional incentive for owners to continue to hold real assets rather than to divest.
Fortunately, the third implication could help mitigate the first two. As rates increase, consumers access greater liquidity in an inflationary economy. One result of inflation is that the market can tolerate rent increases, strengthening a bottom line that faces higher capital costs and lower asset values. On the other side of the coin, the Fed looks to market conditions to determine monetary policy, and a forecast of rising rents a few years from now could be one indicator that the Fed intends to lower interest rates — functionally restarting the cycle.
Economic prediction is a risky game under ideal circumstances, and the complications of a global pandemic only invite more uncertainty to the table. That notwithstanding, the US appears to be on the cusp of economic recovery. Birgo’s official prediction: Interest rates may or may not rise this year. How’s that for precise?! Our conviction is that real estate investors can generate strong returns in both low- and high-rate environments, but there are real strategic differences between those environments, and there’s no substitute for preparedness.