If the end of 35-year bond bull run and record-low interest rates is nigh, how will that affect real estate?
The Federal Reserve raised its target for short-term interest rates by 0.25 percentage points last month.
The Fed's most recent forecast projects U.S. economic growth this year to be 2.1%, slightly better than its previous projection in September.
President-elect Donald Trump's support for expansionist policy, rhetoric-pledging significant spend on new infrastructure, higher exports, higher import tariffs, lower taxes and reduced regulation could spur inflation and lead to higher rates. Many have predicted the end of the 35-year bond bull run and the end of record-low rates.
Yields, which had fallen to as low as 1.5% in the immediate aftermath of the Brexit vote, rose back to more than 2.14% in November, according to data from the Federal Reserve Bank of St. Louis.
As concerns about global economic developments ease, expect those yields to push back toward a more normalized 1.75% to 2% range early this year. The squeeze on cap-rate spreads remains of some concern for real estate investments should rates rise more rapidly than expected, especially because of the "frothiness" seen in certain gateway, Class A markets.
There is little indication that a rate increase will push cap rates dramatically higher. Spreads are still historically high for commercial real estate.
The historical spread for core real estate over the long-term 10-year rate is about 250 basis points. For most commercial real estate, that spread is still 300 to 350 basis points, so we have quite a way to compress before there is upward pressure on cap rates.
Nonetheless, there are indications that yields may begin to drift upward. And as pricing in first-tier markets stalls and yields hover in the sub-4% range in some of the major gateway markets, which are, in some cases, already in peak pricing territory, expect investors to move more aggressively into secondary and tertiary markets and to opportunities beyond core assets to core-plus and value-add properties as well as some of the niche property sectors, including medical real estate.
Another factor in cap-rate behavior is the relative attractiveness to other alternative investments available to the investor.
Corporate credit bonds are yielding in the 2s, S&P 500 dividends are also in the 2s and public real estate investment trusts dividends are in the mid-3s. In this relative low-yield scenario, average private-equity real estate yields are still very attractive and continue to attract capital despite rising rates.
Therefore, the search for yield continues, and despite rising rates, real estate is still a star performer, inducing more capital to come into the sector. That continuing capital demand will put countervailing pressure on cap rates.
This article is commentary by an independent contributor.