Yields Rise As Strong Wages All But Ensure Fed Rate Hike
The ADP report this Thursday marked a significant week for the bond market, as both Treasury and Mortgage rates exhibited a notable increase. Fortunately, Friday’s employment report met expectations, easing some pressure on bonds. The probability of the Fed raising rates later this month is now nearly 100%, with elevated wage inflation and the strong job market. In addition, bond traders are realizing that interest rates will remain high for an extended period, due to persistent global inflation and forecasts of potential interest rate hikes in other countries (like the UK).
Some argue for the Fed to exercise patience and assess the long-term effects of their rate hikes on the US consumer and the economy. Despite this pushback, there are signs that the rate increases are making an impact. Banks are becoming more cautious with their underwriting box, consumers are exercising caution in their purchases, manufacturing data is declining, and credit card balances are rising as stimulus funds dwindle. One might wonder where we would be if the AI investment theme didn’t re-ignite animal spirits. Additionally, large apartment investment firms are facing challenges as floating rate debt reaches a tipping point, where monthly interest expenses exceed property cash flow. The pain of higher interest rates is gradually spreading beyond the office sector to other real estate asset classes.
An illustrative example demonstrates the risks of buying at very low cap rates:
- 2021 Investment Environment Net Operating Income: $100,000 Cap Rate: 3.75% Value: $2,667,666
- 2023 Investment Environment Net Operating Income: $100,000 Cap Rate: 5.75% Value: $1,739,130
This example equates to a loss of almost 35% on the property due to the movement in cap rates. While we don’t anticipate a systemic crisis in commercial real estate, buyers who relied on aggressive assumptions and maximum leverage may face difficulties ahead.
Rate Hikes & Real Estate: What’s Next?
Higher interest rates are influencing the existing housing market, resulting in continually elevated home prices, despite interest rates returning to 7%. This situation may limit what potential buyers can afford. Furthermore, the potential for an increase in housing supply seems plausible if equity markets reverse course in response to ongoing Fed rate hikes. Sellers may choose to sell their homes while existing home market inventory remains tight, rather than waiting for a recession or other negative events. Notably, the Southern California superluxury market is experiencing a swell in inventory as ultra-wealthy individuals are less inclined to expand their home portfolios. It will be intriguing to observe what factors will entice these buyers back into the market. Only time will reveal the answer.