Federal Reserve actions could create an unexpected risk for commercial real estate values.
economy is in uncharted waters. The Federal Reserve has tried to stimulate the
economy through a combination of low interest rates and quantitative easing, a
method of increasing the amount of money in circulation. We hear a lot about
quantitative easing in the news, but few of us fully understand its impact on
the commercial real estate market.
the linkage between the rapidly expanding money supply and inflation does not
seem to be following historical norms. It is possible that three rounds of
quantitative easing, in conjunction with other economic policies, have set up a
scenario that leads to a compression of real estate net operating income and
capitalization rates, meaning demand for real estate continues to grow but NOI
does not, shrinking investors’ return.
consider such future developments in the commercial real estate market, this
article looks at why quantitative easing has not led to a more robust economy,
targeting the declining velocity of money as the broken link.
Much Money, So Little Credit
in late 2008, the Fed introduced a new policy called quantitative easing. Its
overall purpose was to improve the balance sheet of the Fed’s member banks by
buying securities from them, thereby increasing their reserves and putting them
in a better position to extend more credit to the economy. In the first QE
phase from 2008 to late 2010, the Fed purchased approximately $1.3 trillion of
bank debt, mortgage-backed securities, and Treasury securities. QE2, which started
in November 2010 and lasted until June 2011, the Fed purchased $600 billion of
Treasury securities only.
pause of a little more than a year, the Fed commenced QE3 in September 2012,
buying only MBS off the books of banks. It started with $40 billion a month,
then stepped up to $85 billion per month. In June 2013 the Fed announced a
tapering off to $65 billion a month. The capital markets reacted negatively to
the announcement so the Fed postponed the tapering until December 2013, when it
dropped MBS monthly purchase rate to $75 billion. In 2014, the Fed continued
its monthly $10 billion reductions, and, at the end of April, the monthly
purchase was down to $45 billion.
quantitative easing has kept deflation at bay, its restoration of bank balance
sheet reserves and expansion of money supply have produced little aggregate
growth in credit extension, which includes mortgages, commercial debt
financing, and consumer credit. Instead, it has produced a startling
development in the U.S. economy — a collapse in the velocity of money.
measure of how often money circulates through the economy, the velocity of
money trended upward from 1959 through 2008. (See Figure 1.) The only extended
period of sideways oscillation in velocity was during the 1982–93 period, which
coincided with an abrupt slowing in the rate of nominal gross domestic product
growth to 7 percent from a steamy 10 percent rate in the prior decade. The
recent collapse in velocity since 2008, to nearly half its prior level,
coincides with the Great Recession and the ensuing anemic recovery of the
the rapid surge in money supply due to quantitative easing measures, this
growth has not translated into a proportional rapid growth in the economy. This
is due largely to the collapse in the velocity of money — a measure of the
intensity of the use of money, which reflects the opportunity costs associated
with alternative uses of money. For example, turning money on deposit into
loans and investments is driven by the balance of the risk/return appetite of
the lending institution and the opportunities provided on the demand side — the
users of credit. Generally, when there are good risk-adjusted return
opportunities, banks will put every cent to work and will not waste a moment trying
to transform an increased deposit into a productive loan. When opportunities
are poor and interest rates are low, financial institutions have less incentive
to take risks and, therefore, channel their funds into the safest investments,
which, for the past few years, has been the purchase of short-term U.S.
government securities and providing only a limited amount of loans.
loans, of course, result in limited credit growth, if any at all. Since 1950,
total credit extended by the financial sector — depository institutions and the
“shadow banking” system — has never contracted until the most recent recession.
(See Figure 2.) During prior recessions, credit growth went flat, but during
the recent Great Recession, it contracted by 17 percent from the peak in the
fourth quarter 2008 to the low point in third quarter 2011. While increasing
somewhat since then, lending is still 13 percent below the 2008 peak.
while commercial bank lending has rebounded to levels slightly above the
previous peak, this is an incomplete picture of what is really going on. Large
commercial banks have gained market share due to bank consolidation and a
dramatic shift away from the use of commercial paper, medium-term notes, and
traditional non-bank sources of lease and credit financing. These sources of
non-bank, or “shadow banking,” commercial financing have virtually dried up
financing of residential and commercial property has recently stagnated at
lower levels. Consumer credit shows a similar picture of weakness. While
consumer credit, originating from all sources, is growing rapidly, most of that
is not coming from commercial banks and other depositary institutions. In fact,
after removing the portion of consumer credit that is owned and/or underwritten
by the government for student loans, there is very little growth in consumer
credit emanating from banks from the 2011 lows.
lack of growth in outstanding credit means the private sector is deleveraging.
The extent of deleveraging is impressive both as to speed and magnitude and was
not expected to this extent. This deleveraging is likely a long-term positive
for the financial health of the U.S., but in the near term it translates into
addition, this deleveraging implies a challenge for investors. The supply of
new issuances of debt securities is very poor while the demand for these
securities by pension funds and insurance companies continues to grow strongly.
Thus, prices are continually bid up for seasoned outstanding debt and
commercial property, resulting in lower yields and lower cap rates.
summary, quantitative easing has contributed to maintaining interest rates at
historically low levels, but it has not led to the expected increase in
productive lending to finance economic growth. However, on the positive side
for commercial real estate, lower interest rates and a shortage of new debt
issuance have contributed significantly to lower real estate cap rates and thus
higher valuations of investment real estate.
the tapering of quantitative easing proceeds in a slowly improving economy, it
is anticipated that the Fed will eventually start pushing interest rates
higher. Fed forecasts indicate the long-term or target interest rate likely could
be 300 to 400 basis points higher than it is today, but the Fed has indicated
it intends to keep short-term rates low through 2016. If interest rates move up
more rapidly than improving real estate fundamentals and faster than investor
sentiment can tolerate, then cap rates may move in tandem. However,
incremental, slow rate escalation may well be offset in the near term and
result in temporary cap rate compression, especially in view of the short
supply and strong demand for real estate returns.
look at 10-year Treasury interest rates and national office cap rates from 2003
through 2006 shows a negative relationship between the two measures. (See
Figure 3.) Capital was plentiful during that period. Then as the Fed began
lowering interest rates, cap rates showed a limited negative relationship but,
by and large, were confined to a narrow range. (See Figure 4.) A lack of
liquidity as well as negative investor sentiment contributed to the negative
relationship. It is abundantly clear then that cap rates and interest rates do
not always move up or down in tandem. However, when there is neutral investor
sentiment and level but stable fundamentals, cap rates usually do move up with
interest rates, thereby resulting in a reduction in values.
the Fed will move interest rates higher. Shrewd investors are already
questioning where cap rates will be four or five years from now. Recently
acquired deals with a low going-in cap rate of 4 percent or 5 percent may take
a valuation hit in the future if the interest rate and cap rates move higher
and faster in tandem and outstrip the positives of improving fundamentals and
improving investor sentiment.
buyers now are using a snapshot version of NOI to value properties (the
going-in cap rate) with little consideration given to anticipated changes in
NOI and, therefore, value. If anything, the implicit assumption is that NOI
will increase. Therefore, as the economy improves with greater investor
confidence, even as inflation becomes more of an issue, investors will
presumably be more aggressive in assuming a higher value on sale.
since most leases are not full triple net and the extent and type of lease
escalators vary from fixed to variable, there is a risk not being considered.
What if rents cannot rise as rapidly as owner operating costs increase?
Currently, the most frequently used inflation escalator is the consumer price
index. It has been fairly docile in recent years and Fed’s longer term target
is in the 3 percent range. But have building owners considered that operating
costs might rise more rapidly than lease escalator clauses permit to be passed
the costs of operating a building are service related and, as such, are labor
intensive. Government initiatives to raise the minimum wage, require employers
to pay overtime to salaried workers, and increase health care and other benefit
costs are sure to raise the cost of service. Productivity gains in the service
sector are hard to come by, so most of those costs will be passed on. The CPI,
of course, measures the prices of goods as well. Therefore, it is possible in a
world of sluggish economic growth and excess capacity, for those prices to
remain steady. Any attempt to estimate the components of future inflation rates
is very difficult, but consider this scenario as a starting point. What if the
CPI were to increase at a steady 3 percent, while the cost of all services
purchased by property managers increased by 7 percent? Would that not squeeze
are many possible scenarios that can unfold. Predicting the path of economic
growth and inflation is fraught with uncertainty. However, a scenario that
might simultaneously increase the demand for real estate while at the same time
compressing NOI growth potential could lead to lower ROIs than one would
van Kipnis is a retired Wall Street economist and hedge fund executive and
currently teaches at Spring Hill College in Mobile, Ala. Contact him at
firstname.lastname@example.org. C. William Barnhill, CCIM, is president of Omega
Properties in Mobile. Contact him at email@example.com.