Rate Hikes and the Market: A Love Story
Marcus Leoni
You’ve heard rumblings coming from every corner of the market that the Fed is going to hike interest rates this year. Markets cringe, contract, and warn consumers that the inevitable is only just around the corner. So, where is this rate hike? Why does it matter? Most importantly, what effects will it have on the commercial real estate markets?
The Basics
The Federal Reserve Open Market Committee, through open market operations, helps to determine the effective interest rate for institutions to borrow funds from one another.for market liquidity and the flows of funds to all sorts of consumers. They study market conditions and use several key indicators to set a target fed funds rate. Simply put, when depository institutions like JP Morgan Chase or Bank of America have excess deposits with the Federal Reserve, they lend the excess funds to other institutions overnight. The price paid by these firms is the Federal Funds Rate; almost every interest rate in the market comoves based on this rate.
The Federal Open Market Committee and You: A Love Story
Maybe a love story isn’t the first thing that comes to mind when you’re thinking of the Federal Reserve’s Open Market Committee. However, the relationship between the Federal Reserve and the public is something out of a Shakespearian novel. A long, dramatic, twisting tale with equal parts triumph and tragedy.
Economics is really the study of decisions and the price paid for those decisions. In this case, the Fed must meet its core mission: the infamous dual mandate. When the government entrusted a quasi-private body to take care of the nation’s finances, it mandated that the Fed keep employment up and inflation down. Of course this is an insanely simple version of their day-to-day operations, but thats the Readers Digest version.
Federal Reserve Open Market Committee meetings occur eight times a year. Taking a quick look at the time-series above, you can quickly tell interest rates are hovering near absolute historic lows. Business can operate and produce for costs never before experienced in modern history. Capital markets are experiencing fantastic growth and confidence has seeped its way into all corners of the market; the same corners quietly groaning at the possibility of increased rates.
The Nitty Gritty
Real estate markets rely heavily on financing to complete transactions. On the residential side, lenders resell mortgages originated to consumers back to Fannie Mae and Freddie Mac, the two Government Sponsored Organization powerhouses. Strict lending requirements are enforced across the board with near perfect adherence after the fiasco of the 2008–2010 “Great Recession” which found its roots in the 10 years leading up the fantastic implosion of the market; a pandemic that infected every corner of the globe. Commercial lending is another animal entirely, and the focus of this article.
Capital markets are experiencing fantastic growth and confidence has seeped its way into all corners of the market; the same corners quietly groaning at the possibility of increased rates.
Institutions lend money to make large-scale deals happen along with private equity, individuals, a whole slew of other complex financial vessels to deliver money to the necessary hands. These institutions borrow money from the Fed at the Federal Funds rate and make money on the net between the borrowed rate and the lendable rate. So, in short, it seems that increasing the Federal Funds Rate will make the cost of borrowing more expensive. As the cost of borrowing goes up, the rate that consumers pay goes up and so on.
Consumers, in this situation, are developers and large life insurance companies that commonly finance large commercial real estate transactions. It’s very difficult to predict what firms will do when the cost of borrowing goes up. Historical data collected by the Census Bureau charting new home starts show that interest rates moved along interest rates in the lead up to the Great Recession. Between 2000 and 2006, new home starts increased about 500,000 units total per year while interest rates rose around 3%.
Tidying Up
The truth is that not one single person can predict the results of the nearly inevitable rate hike that will occur within the next 6 months. Markets have been tumultuous during the past year exemplified by the Chinese stock market crisis this past Summer and the instability of domestic markets. If history is a predictor, markets will slowly recover along with the rate hike and eventually level out at a much more modest level than the tumble taken from 2006–2008. Development and construction will inevitably slow (gradually) and continue on a growth trajectory for many years to come.
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