The current era of inordinately low interest rates is entering its fifth year. The casual observer (e.g., the homebuyer) may be pleased with this phenomenon. However, I am concerned that such financial engineering by the Federal Reserve is contributing to the mispricing of assets, including commercial real estate.
The initial raison d’être for such borrowing costs was the depth of the recession and the perceived need to stimulate economic activity. However, the federal government has long since proclaimed the recession over and that the economy is in recovery, albeit a tepid one. Nonetheless, the Fed continues to maintain historically low interest rates.
Investors have seized upon such low-debt costs and have priced assets accordingly. Prices have increased beyond those which are supported by economic fundamentals. Most will agree that growth in employment and income—key drivers of demand for all types of real estate—has been sub-par at best.
Changes in rates of return (“cap” and discount rates) have a much greater impact on the value of commercial real estate than do changes in rent and expenses. If the costs of debt rise significantly (a virtual certainty), the resulting cap and discount rates will obviously rise as well. No one can say when this will occur, but few will argue that it won’t.
Call me cynical, but could the Fed be intentionally sowing the seeds of hyperinflation to lessen the burden of repaying our massive governmental debt? This tactic has long been used in less-developed nations, but never in the United States, at least to my knowledge.
If sharp rate increases are eight to 10 years away, perhaps my concerns are unjustified. If they occur much sooner, properties bought on a 6 percent cap rate may disappoint investors forced to sell at 7.5 percent to 8 percent.