Federal Reserve actions could create an unexpected risk for commercial real estate values.
The U.S. 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.
Furthermore, 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.
To 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.
QE: So Much Money, So Little Credit
Beginning 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.
After a 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.
While 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.
A 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 economy.
Despite 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.
Limited 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.
However, 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 since 2009.
Mortgage 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.
This 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 economic weakness.
In 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.
In 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.
What About Valuation?
While 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.
A brief 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.
Ultimately 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.
Many 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.
However, 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 along?
Much of 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 NOI?
There 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 normally anticipate.
By: Gregg van Kipnis and C. William Barnhill (Commercial Investment Real Estate)
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