Fretting Over the Fed

A close look at how the US Federal Reserve Bank functions and how they influence the value of your real estate.

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We decided to take a short break from our series on When is More Just More and the adventures of Mr. Smith, to share some thoughts with you on another front-and-center topic: Monetary Policy.

Mr. Smith will be off enjoying his after-tax profits for the week, but he’ll be back. We also have a real Mr. Smith, a friend of ours who is a lot like our fictional character, who has agreed to an interview with us to discuss his thoughts on how his life has changed since he discovered when more became just more for him.

So, that’s in the works and we will be sharing the interview with you soon. Now, on to our fret over the Fed…

Let us first say that we are not economists, but we believe that a fundamental understanding of how the Fed functions is critical to our ability to serve you, our valued clients.

Why?



Because the Fed, by using the tools at its disposal, controls the flow of and the cost of capital, plain and simple. 



Plus, now more than ever – 



Investors at all levels must keep a vigilant eye on the actions of the Fed. Click To Tweet

That fact is sure to impact decision making in all asset classes to some degree.

Monetary policy can be generally described as the actions of the US Federal Reserve Bank, currently under the leadership of Janet Yellen, the first woman to hold the position as Chairman of the Board of Governors. She is assisted by the Presidents of the 12 Federal Reserve Banks located in Atlanta, New York, San Francisco, Denver, Cleveland, Dallas, Minneapolis, Richmond, Chicago, St. Louis, Philadelphia and Boston.

The Fed’s structure includes a seven-member, Presidentially-appointed Board of Governors and a Federal Open Market Committee (FOMC), which includes the Board of Governors and five Reserve Bank Presidents that are appointed to one-year terms on a rotating basis.

Of note is the fact that the FOMC always includes the President of the New York Fed. We are looking into why that is, but it probably has something to do with the fact that New York has the tallest buildings. If we find out anything different, we will let you know.

The Fed’s primary objectives, as outlined in its charter enacted back in 1913 by an act of Congress, is to keep inflation and employment in a balance that promotes economic stability. In other words, protect the buying power of the US Dollar and promote economic activity that generates jobs.

As a result, the entire Fed system keeps a close eye on several inflation and employment indices, along with GDP, the money supply and a variety of other economic metrics.

Monetary policy, then, is the actions taken by the Fed at any given time to influence inflation and employment. They have several ways of manipulating the cost of capital, which are intended to either stimulate or restrict economic activity in a way that keeps inflation and employment in balance.

The first and most widely known of these methods is the raising or lowering of its key overnight lending rate, or Fed Funds Rate, also described as the rate at which member banks from the private sector charge each other for overnight loans from their own reserves deposited at one of the 12 Federal Reserve Banks.

When that rate goes up, the rate on every other kind of loan will go up, as it is seen as a signal of what’s to come. When that rate goes down, the reverse is generally true. By making money more expensive to borrow, economic activity should slow down and that theoretically brings inflation down.

When money gets cheaper to borrow, demand for borrowing increases, more businesses and properties are financed and the increased economic activity should lead to more jobs that lower the unemployment rate, at least until a fully employed economy overheats and sets off another spike in inflation.

Think of it as the pedals on the floor of your car. Hit the gas (lower rates) and you speed up. Hit the brakes (raise rates) and you slow down. That is essentially what the Fed is doing every day, hopefully, without having to bury the gas pedal or stomp on the brakes, which can lead to dangerous market volatility. For those of you who were around in 1982, you know of what we speak.

Then-Fed Chairman Paul Volcker hit the brakes so hard that he sent rates into the stratosphere to stamp out a bout of persistent inflation. The Prime Rate hit 22.5%. Compare that to today’s prime rate of 3.75%. If you weren’t around for that, good for you. It was ugly.

Another of the Fed’s ways of manipulating the flow of and cost of capital is known as Quantitative Easing. Simply put, the Fed creates money in a computer, buys existing US Treasuries bonds to put cash to lend back in the hands of the bondholders and puts the bonds it purchases on its own balance sheet as an asset.

Nice trick if you can get away with it; and they did…to the tune of $4.5 Trillion, with a blend of US Treasuries and Residential Mortgage-Backed Securities (RMBS). The RMBS buybacks were designed to lower interest rates on private housing to help the recovery from the subprime mortgage meltdown of 2007 and 2008.

Long story we don’t have time for here, but suffice it to say, the Fed created all that cash with little electronic ones and zeroes in a computer, and also kept its benchmark Fed Funds Rate at essentially 0% for seven years, before finally calling a halt to the stimulus (letting up on the gas pedal). You just can’t make this stuff up. Thankfully, Quantitative Easing ended nearly two years ago and its efficacy is still under debate.

Why are we fussing about this? What does it have to do with the value of your real estate? Good questions. Our response: the Fed has begun to reverse its monetary policy and slowly move its collective foot from the gas to the brake. That means borrowing will intentionally get more expensive and that means mortgage interest rates on properties like yours will go up.

There is no denying that the run-up in commercial real estate values has been mainly driven by the Fed’s lead foot. So, it only makes sense to pay close attention to the real estate market when the Fed takes its foot of the gas and starts to cover the brake.

When rates go up, borrowing power erodes and prices tend to come down to make property ownership make sense again. When rates are down, buyer demand increases, supply runs short and prices rise rapidly. That is exactly what happened in Orange County.

Add the fact that there’s little land left for new products to be built and the supply/demand imbalance was thrown further out of whack. Hence, our fictional Mr. Smith was able to buy a building in 2010 for $100 per square foot and sell it seven years later for $210 per square foot.

Mortgage rates are still near historically low levels, but that may soon change. How can we say that with confidence?

Here’s why: commercial property interest rates are benchmarked to the yield on the 10-Year US Treasury bond, the ‘theoretically’ riskless investment by which all other investment yields are underwritten, and that yield is directly impacted by monetary policy.

When the Fed applies the brakes by raising rates, the yield on the 10-Year goes up. If the Fed hits the gas pedal, it goes down. In either case, the expected yields on other investments move in the same direction, since investment risk premiums are benchmarked to the 10-Year Treasury.

So, an investor simply adds a risk premium based on the asset class and an assumption of risk factors to come up with the yield he needs to make on a particular investment. Right now, the yield on the 10-Year Treasury is hovering about 2.3%. A year ago it was at 1.6%.

Cap rates for good industrial real estate are running in the 5% to 6% range right now. Assuming that the spread, or risk premium, over the 10-Year Treasury stays the same and the yield on that bond goes to 3.3% due to further Fed action, do the math. Buyers will be forced to offer a higher cap rate, which means a lower price.

We don’t mean to say that spreads move in lockstep with the benchmarks, but they do tend to correlate. This is why we fear a correction sooner than later.

This has gone longer than we expected. So, we will continue next week.

In the meantime, keep one eye on the 10-Year Treasury yield. It’s right at the top of the Wall Street Journal homepage. Until next time…