How rate hikes will impact the commercial real estate market

By now you have likely heard about the Federal Open Market Committee’s vote in December to raise the federal funds rate for the first time in almost 10 years.

And if you haven’t, well, it’s time to take a crash course in what’s going on, and specifically how it will impact our local economy.

Mostly symbolic, this initial rate increase was just the first step in what will likely be a drawn-out process of monetary policy normalization. An important conclusion we can draw is that it reflects the FOMC’s belief that the labor market is close enough to full employment.

While a 25-basis-point increase alone is not very significant, what matters most is where things head next. We can reason that monetary policy, via the federal funds rate, will remain favorable in the near future. Also, current market conditions suggest inflation will remain below 2 percent for the next 10 years.

With a basic background as to what’s going on, let’s dive a little deeper into what this activity means for our economy, specifically for commercial real estate.

It’s not the federal funds target rate, or even the 10-year rate, that impacts commercial real estate the most, but rather economic growth and job creation. These factors have greater influence over lower vacancy rates and higher rental rates that really impact a building’s pro forma. Simply put, economic growth has a far greater influence on property values.

That’s not to say the commercial real estate sector hasn’t benefited from the Fed’s massive injection of liquidity into the economy over the past seven years. Overall, prices have nearly recovered, and for some real estate segments, local market prices actually exceed prerecession peaks.

With the FOMC’s goal of normalizing interest rates, it’s reasonable to be concerned that rising rates will reduce investor demand for commercial real estate. However, I expect that commercial real estate prices and returns will continue to be attractive even in a rising interest rate environment.

There is more than one factor driving long-term interest rates. Take for example inflation (a major driver of longer-term yields), which is expected to remain low over the next decade.

Additionally, our nation’s overall improving economic conditions, including a strong labor market, have helped to drive the Fed’s decisions. Nonfarm payrolls have increased by just more than 5.5 million jobs since the end of 2013.

It is likely that 2014 and 2015 will be the strongest back-to-back job growth years since 1998 and 1999. Job growth is another major factor that continues to drive the improving leasing market fundamentals across the nation.

If we look to history for examples as to what to expect next, it’s that a rising federal funds rate has most often coincided with tightening commercial real estate markets and rising prices. Two similar instances have both been accompanied by rising office occupancy rates.

From 1993 to 2000 the federal funds rate rose from 3 percent to 6.5 percent. Office occupancy during that period increased from 79.6 percent to 90.9 percent. Similarly, from 2003 to 2007 the federal funds rate rose from 1 percent to 4.25 percent and office occupancy increased from 80.5 percent to 87.1 percent.

What we are currently seeing on a national level follows suit with these predictions. Commercial space is being absorbed, vacancy rates are falling and rental rates are rising. In third-quarter 2015, the national office vacancy rate fell to 14.2 percent, its lowest level in seven years.

According to F.N.B. Wealth Management, traders now believe the Fed is likely to hike rates just once in 2016, most likely not before September. This contrasts with earlier predictions that the Fed could move two or three times this year.

As it pertains to commercial real estate, we should take this news in stride. Thus far, the federal interest rate hike has signaled a recovering economy and has not deterred investors and developers from diving into the market.

An increase in absorption and rental rates and a decrease in vacancy rates are welcome side effects that are far more positive than what many other industries may be experiencing as a result of these economic changes.

For Central Pennsylvania’s commercial real estate investors, sellers and brokers, we should use what history has already taught us about the typical “tightening cycle” to our advantage to determine how we monitor and approach the market over the coming years.

Mike Kushner is the owner of Lower Paxton Township-based Omni Realty Group.

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