Federal Reserve Chair Janet Yellen gave a speech last Friday in which she strongly suggested that the central bank would raise the federal funds rate this month. This rate, the Fed’s most important economic lever, has hovered around historic lows since the early days of the recession. This move will have important effects for the credit-dependent commercial real estate sector.
As for what the effects of this specific rise in rates might be, there are almost as many predictions as there are economists to make them. For a look at the sheer diversity of opinions, it’s worth reading through the following article by Biznow’s Elliot Golan, in which he polled 10 top economists for their predictions. Instead of stepping on his toes, let’s look at what, precisely, the federal funds rate is, how manipulation of the rate carries into the larger economy, and how this generally affects the commercial real estate sector.
What is the federal funds rate?
To understand the federal funds rate, first it is important to know that the Federal Reserve requires that member banks keep a reserve balance equal to a percentage of their total deposit liabilities. In other words, banks have to set aside a portion of the money customers deposit with them and park it with the Federal Reserve. The share of deposits depends on the size of the institution.
The numbers involved in this requirement vary daily, so banks have to satisfy their reserve requirements overnight. Often, banks come up short or find that they have excess reserves. When banks don’t meet their reserve requirements, they are required to make up the difference by borrowing money from banks that are holding excess reserves or, failing that, directly from the Fed.
The average of the rate at which banks borrow from each other in this setting is called the federal funds rate. When banks borrow from each other in order to finance large projects or more lending, they do so at a rate that is equal to or higher than the federal funds rate, meaning that it sets the floor for all loans. This will be important to remember later.
Despite common perception, the Federal Reserve does not directly set the federal funds rate. Rather, it has a suite of economic “tools” – called open market operations – that it can use to move the rate toward the rate target, which is set by the Fed governors at Federal Open Market Committee meetings. Through open market operations, the Fed is essentially injecting or withdrawing liquidity from money markets.
The Fed also sets a cap on the federal funds rate by directly setting the rate at which member banks can borrow from it directly. This is called the discount rate. No bank would ever borrow at a federal funds rate higher than the always-available discount rate, so it cannot be outpaced. In October 2008, the Fed also gained the power to offer interest on the reserve balances held by banks. No bank will lend out money to another bank at an interest rate lower than the rate it is already getting by doing nothing, so this effectively sets a floor for the federal funds rate.
How does the federal funds rate affect the economy?
Anything that a bank can do with a given dollar must be weighed against the option of lending it out at the federal funds rate. For example, if the federal funds rate is 5 percent – roughly what it was just before the 2008 recession – it would be a mistake for any bank to lend money out at below that rate; they would be leaving money on the table.
Now that the Fed pays interest on reserve balances, there is no longer an incentive to shoot for exactly the required reserve balance. As a result, the odds of any bank coming up short are much lower and so there are considerably fewer transactions at the federal funds rate. The result is the same, however. No bank would lend money out at a rate lower than the interest rate offered by the Federal Reserve.
In this way, the federal funds rate sets a floor for all interest rates in the economy. Banks can and do lend to each other and to consumers at rates above the federal funds rate, but the opportunity cost of not keeping any given dollar in their reserve balance means that the rate is baked into all other interest rates.
Interest rates are inversely correlated to borrowing. When interest rates are high, fewer businesses and consumers want or can afford to borrow money. This results in fewer loan originations, less new construction, and reduced business activity throughout the economy.
How does Fed policy affect commercial real estate?
The amount of borrowing in the economy has direct and indirect impacts on commercial real estate. Before we get into that, it is important to note that, while higher interest rates appear to move both metrics in a more challenging direction for the industry, the Fed is responding to positive economic indicators in making its decision to raise rates now. In general, the Fed carefully raises rates when the economy is growing in order to avoid bubbles, keep growth sustainable, and give itself slack in the line to lower rates during recessions.
Rates for commercial mortgages, like almost all loans, are subject to fluctuation based on the federal funds rate. Any increase in the Fed rate results in a corresponding increase in the rates for commercial mortgages. Increased financing costs diminish the demand for commercial real estate, thereby increasing capitalization rates. Capitalization rates, or cap rates, are a ratio of net operating income to property asset value. As a result, higher interest rates are generally good for cash buyers and bad for businesses and individuals buying or constructing new buildings on credit.
Higher interest rates also slow down other investments throughout the economy. This means fewer companies being started and expanding, which results in less demand for commercial real estate purchases and rentals. It also may mean diminished consumer spending, but it is worth noting that higher interest rates tend to decrease inflation. High inflation, especially if it outpaces wage growth, can also decrease consumer spending.
While none of that sounds good, higher interest rates are an important part of preventing bubbles, avoiding recessions, and making recessions shorter and shallower when they occur. The real estate industry, because of its perception as a safe investment, is particularly vulnerable to this type of disruption.
It is also the case that a rising Fed rate signifies confidence in the strength of the economy. If this assessment proves to be correct, improving occupancies and rent growth would likely increase property values enough to eclipse decreases from higher mortgage rates.
The ultimate success of this – and any – Fed rate change hinges on the Fed governors correctly reading economic signals. Even within the Fed, there are officials who disagree with Yellen’s assessment, but economists on the whole appear to be optimistic that a reasonable March increase is the prudent choice.