No Alarm Bells After Minimal Interest Rate Hike

News and predictions surrounding interest rates have dominated industry headlines for quite some time. The Federal Reserve’s first interest rate hike since 2006, which arrived in mid-December after months of speculation, should act less as a cause for alarm than as a bellwether of even better things to come for the economy as a whole, as well as the CRE industry.

Because the hike is largely symbolic and indicative of the Fed’s view of strengthening market fundamentals, it is not expected to hinder CRE activity. While some in the industry may be disappointed to see the end of historically low rates that helped the CRE industry recover from the Great Recession, the economy’s increasingly stable footing should only help propel the industry and will outweigh any potential negative effects of the quarter-percent interest rate hike.

Though longer-term concerns could bubble up, it’s unlikely that the increase will negatively or greatly impact the sector, or cause a slowdown in development or investment activity in the near term. Unemployment is falling, oil prices are expected to remain low through 2016 and housing prices have recovered in many markets, bolstering economic stability for consumers and tenants alike. Greater consumer confidence also presents the opportunity to command higher rental rates, generating better cash flow for REITs.

The potential short-term impact of the hike might have been overblown primarily because it had been top-of-mind among REITs, and industry players were well prepared for the adjustment. Many REITs have likely already factored the potential risks associated with a rate increase into their strategies, and some have already done much of the heavy lifting by preparing for a more dramatic increase than the quarter percentage point.

Assuming future hikes follow the gradual pattern discussed by the Fed of four small increases throughout 2016, the higher interest costs should be offset by increases in rental rates. This would be helped along by both inflation and strengthening economic fundamentals. If the increases in rent are greater than the incremental increases in interest costs, this would generate excess cash flow and allow REITs to pay greater dividends in the coming years.

Looking further ahead, once rates increase by another 50 or 75 basis points, REITs’ risk-adjusted returns may not be as attractive to investors, and they may need to revisit their distributions. If rates were to climb higher than expected or the pace were to pick up, interest costs would be more likely to hamper REITs’ valuations, distributions to shareholders and ability to finance new properties.

All things considered, one prediction to remain absolutely certain of is that the fate of rates will continue to be subject to widespread speculation and will be a key market driver for REITs in the year ahead. 

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By Stuart Eisenberg. This article originally appeared in BDO USA, LLP’s “Real Estate Monitor Newsletter” (Spring 2016). Copywrite 2016 BDO USA, LLP. All rights reserved.