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Federal reservations

All eyes are on the Federal Reserve and how decisions made at its upcoming meeting could lead to a greater focus on secondary US cities and value-added investments.

Amid the building frenzy over a wave of new economic reports this month and the potential for another looming showdown over the US debt ceiling next month, the news that is likely to have the most significant impact on real estate investing in the US comes on September 17 and 18. That is when the Federal Reserve will decide whether to reduce its $85 billion monthly stimulus, known as QE3, which has helped keep long-term borrowing rates low.

The concern among real estate investors is the rise in the cost of debt capital and whether that cost has plateaued or will continue to move up. Over the summer, speculation on Fed action triggered a bond market sell-off that sent mortgage rates to two-year highs, a situation that has shown signs of slowing the US housing recovery. Should borrowing costs go up much further, leverage will become less attractive for large investors as well.

Today, the long-term rate is 2.75 percent and anything up to 3 percent should be palatable for the market. Rates at those levels would maintain the momentum of the current real estate recovery, according to market experts. Once rates reach 3 percent, however, we enter a territory that the market has not seen in a while. That could prompt some investors to go back to their models and look at pricing and valuation differently, one expert noted.

A greater increase in rates to between 3 percent and 3.25 percent could stop the upward momentum currently enjoyed by the real estate market, the argument goes. Indeed, at 3.5 percent, the market could even see a pullback in pricing.

Of course, it is important not to believe higher rates automatically mean a change in fundamentals for real estate. The industry’s reaction also depends upon what comes with higher rates. A continued improvement in underlying fundamentals, such as employment or consumer spending, could help to offset some of the impact of higher rates.

Still, higher rates likely will prompt a number of investors to look for higher returns. For some investors, that could mean moving away from real estate altogether, thus shrinking the overall pool of capital focused on the asset class.

For those investors sticking with real estate, they will need to look beyond core properties in gateway markets for better total returns. That would infer a greater focus on secondary US cities and value-added investments in the months ahead.

Much still depends upon the Fed’s course of action. Recent economic data has failed to provide evidence of the convincing growth that the Fed claims it wants to see, and a weak August jobs report has done little to reinforce the view that the Fed will opt to decrease its bond purchases. So, until the Fed actually does wind down QE3, property investors in the US will continue to benefit from what has been a historically low cost of debt capital.