Marcus & Millichap: Fed ‘Normalization’ Will Affect CRE

The Federal Reserve’s plans to ‘normalize’ monetary policy following nearly a decade of easing–and the resulting rising cost of capital–could weigh on commercial real estate investor activity, said Marcus & Millichap, Calabasas, Calif. 

“Although the Federal Reserve has raised short-term interest rates four times since the financial crisis took them to zero, the [Fed’s] balance sheet has remained consistently near $4.5 trillion as interest and proceeds from investments have been rolled over into new securities,” Marcus & Millichap Capital Corp. Research Analyst Aaron Martens said in a special report. But Martens said the rollover process and the Fed’s balance sheet will soon change because the Fed has outlined plans to allow $6 billion of Treasury securities and $4 billion in mortgage-backed securities to roll off its balance sheet every month to move toward what the Fed calls normalization.

“The Fed plans to gradually increase the amount allowed to mature to $30 billion in Treasurys and $20 billion in mortgage-backed assets as the process moves forward,” Martens said. “A wind-down of acquisitions by the Fed–one of the largest buyers of long-term debt–will exert upward pressure on long-term rates.”

Martens said most commercial real estate investors expect a “modest” increase in interest rates, pushing up the cost of capital. But some investors actually anticipate short-run declines in Treasury yields because the untested Fed moves could increase rate volatility, he noted. “The yield spread between long- and short-term Treasury rates is closely monitored as a sign of an impending recession,” he said. “When the yield on short-term rates exceeds the yield on long-term rates, the yield curve turns negative. For every recession since the 1970s, the spread has gone negative at least 12 months before the onset of a recession in the business cycle. This poses a challenge for the Federal Reserve as it attempts to lift the overnight rate.”

Commercial real estate fundamentals remain strong, but rising debt financing costs will tighten the spread between cap rates and lending benchmarks, Martens noted. “This environment could weigh on transaction activity as investors evaluate their yield options,” he said. “Cap rates have remained relatively stable over the last year, but upward movement in Treasury rates has amplified the ‘expectation gap’ between buyers and sellers.”