Interest Rate Indexes: Falling Leaves and Rising Rates
There are two key interest rate indexes commonly tracked in real estate: the Federal Funds Rate and the 10 Year Treasury Yield.
Federal Funds Rate
The Federal Funds Rate is the target interest rate range at which banks lend reserve balances to other banks on an overnight basis. The Federal Open Market Committee (FOMC), which is a part of the Federal Reserve System, sets the federal funds rate target. The federal funds rate is a key tool used by the Federal Reserve to manage the country's monetary policy and achieve its economic objectives, such as promoting maximum employment, stable prices, and moderate long-term interest rates.
When the Federal Reserve increases the federal funds rate, it becomes more expensive for banks to borrow from each other, leading to higher interest rates for consumers and businesses. On the other hand, when the Federal Reserve decreases the federal funds rate, it becomes cheaper for banks to borrow from each other, resulting in lower interest rates for consumers and businesses.
In March 2020, the U.S. central bank held an emergency meeting where the Federal Funds Rate was reduced to a 0.00%-0.25% target range in response to the fallout from the stay-at-home measures of the Covid-19 pandemic. Additionally, former President Trump signed the $2.2T CARES Act which had an immediate impact on the economy compared to the $831B 2009 Recovery Act from Obama’s administration which took years to circulate. This period was struck with a 31.4% GDP plunge in the second quarter of the year, followed by a 33.4% GDP increase1. In retrospect, the CARES Act and reduction of the Federal Funds Rate allowed for this unheard-of recovery to begin in May 2020, marking the end of the shortest recession in U.S. history.
Ultimately, the central bank's decision to pause any increases of the Federal Funds Rate from May 2020 to March 2022 along with the Biden administration’s $1.9T American Rescue Plan in January 2021 inflamed the economy. With over $4.0T of cash infusion into the economy in less than two years, inflation began to rise substantially in March 2021. By March 2022, the U.S. central bank was compelled to implement a series of aggressive Federal Funds Rate hikes over the subsequent 18 months, leading to a 20-fold increase over their next 11 meetings from 0.00%-0.25% to 5.25%-5.50% by September 2023. This sudden rise resulted in the temporary suspension of many real estate transactions with the total estimated amount of real estate transactions over $1.0M in the first half of 2023 dropping 41% compared to last year2.
10 Year Treasury Yield
The 10 Year Treasury Yield refers to the interest rate that the U.S. government pays to holders of the 10 Year Treasury Note. It represents the annualized return on investment for those who purchase the bond at its current market price and hold it to maturity. The 10 Year Treasury Yield is a critical indicator for the broader economy and financial markets, as it often serves as a benchmark for other interest rates, such as mortgage rates, corporate bond rates, and other forms of consumer and business lending rates.
Investors and analysts closely monitor the 10 Year Treasury Yield as it reflects investor confidence in the economy, inflation expectations, and monetary policy. When the yield rises, it typically suggests that investors are demanding higher compensation for the perceived risk of inflation eroding the value of their investment. On average, the 10 Year Treasury Yield has hovered between 2% and 3%. However, as of 2020, this yield dropped below 1%, triggering a buying frenzy that lasted nearly two years. Thus, the first half of 2022 was the most active half for real estate transactions in history2.
These past few weeks brought a dire turning point as the 10 Year yield reached 5% for the first time since 2007, contributing to the temporary halt in many ongoing projects. These projects are reviewing their financial viability as they are no longer able to reach their targets due to the effect of this yield increase in the lending market. Lenders are continuing to widen their spreads over the 10 Year, due to increased concerns of the government's ability to repay its debts. This sharp increase is not only affecting development, but it also has a cascading impact on mortgage rates, auto loans, and various other consumer loans.
Our Vision
For contrarian investors, this market situation presents a significant opportunity. Major institutional and real estate trusts, which were typically all-cash buyers, are currently on pause due to the large number of deals in the previous two-year period. This period creates an opening for regional buyers with strong credit and liquidity to enter the best buying market since the early 2000's.
For instance, when the 10 Year Treasury was at 1%, average Cap Rates were around 4% or 300 basis points higher than the yield. Presently, with the 10 Year Treasury slightly below 5%, Cap Rates average around 8.5%, with concerns about potential further increases. Despite this, investors anticipate a rate decrease within the next 12-24 months which could pull Cap Rates down. Additionally, for those who are currently making aggressive acquisitions, the potential opportunity to refinance at lower rates in the future could increase their cashflow substantially.