Five repercussions of the Fed’s rate cut for real estate investors

Falling rates can boost real estate in the short term. But institutional capital has reason to worry about a lower-for-longer environment.

On Tuesday, after several days of stock market selloffs, the US Federal Reserve announced an emergency rate cut to quell concerns over the coronavirus outbreak and buttress the economy against a potential downturn. It was the first time the central bank has taken this measure since the global financial crisis.

The 50 basis point drop did not instill much confidence. The Dow Jones Industrial Average plummeted 800 points immediately and 10-year treasury yields fell below 1 percent for the first time.

However, the Fed’s cut delivered a message to the rest of the global economy: low rates are here to stay. And, if last year’s cut is any indication, other central banks around the world are likely to respond in kind.

At first blush, a global ‘lower-for-longer’ interest rate environment appears to be a windfall for commercial real estate, especially as uncertainty impacts confidence in other asset classes. Yet, as we explore in this month’s cover story, beneath the shiny veneer of easy money are many layers of uncertainty for investors.

Here are five reasons the current interest rate environment is worrisome for institutional capital in private real estate.

  1. Rising costs

As demand increases, property prices are likely to rise, even if net operating incomes remain unchanged. While cap rate compression is viewed positively by some market participants, its benefits skew toward current property owners looking to sell, or managers hoping to pump up their portfolio values. For new capital committed to the asset class, the prospects for deploying into bargain buildings are not promising.

  1. Diminished returns

While some funds will benefit from higher asset prices in the short term – especially those exiting – sustained low rates typically lead to poorer performance in the long run. Appreciation drove real estate returns between 2010 and 2015, but they have steadily fallen since, accounting for just 1.8 of the 6.4 percent total one-year returns tracked by the National Council of Real Estate Investment Fiduciaries Property Index in 2019. That trend is likely to continue given central banks’ embrace of lower for longer.

  1. Risk incentives

Without appreciation, managers need to boost returns in other ways. The most vexing example of this is the use of leverage to achieve returns through financial engineering. While this has yet to manifest systemically in the current growth cycle, firms have added risk in other ways. Untested property types, such as self-storage centers, have become popular, as have operationally intensive business models, such as flexible offices, student housing and senior living. The longer low interest rates persist, the more investors will have to rely on things other than traditional real estate for real estate returns.

  1. Slow growth

The most troubling aspect of low rates is what they say about the broader picture. Low rates indicate tepid growth and economic instability, both of which undermine the fundamentals of real estate performance. Rising rates are likely to coincide with business expansion, household creation and consumer spending. Without those elements, real estate becomes susceptible to stagnation.

  1. No cushion

Should the global economy slip into a recession – an increasingly likely scenario as the coronavirus spreads – central banks have little cushion to break the fall. The US Federal Funds Rate target is between 1 and 1.5 percent, and many European countries are hovering around zero. While negative rates can provide a temporary boost to real estate markets, they would do little good if a downturn were to hamper tenant demand.

The depths of the coronavirus outbreak and its ability to seize countries with fear remains to be seen. Early indications are of hammered investment volumes at least until later in the second half of the year. What is clear now is the vulnerability of the global economy and, by proxy, its commercial real estate markets. As government bonds go into free fall and public equities swing wildly, institutional investors have little choice but to trust private real estate as part of the plan to see them through the storm. But that does not mean they will enjoy the ride.

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