10-Year Treasury Breaks 3 Percent; Higher Rates a Positive Sign for Commercial Real Estate?

Rising interest rates spark fear from investors but reflect persistently strong economic growth that underpins commercial real estate performance. The 10-year Treasury rate inched past 3 percent for the first time since late 2013 following the “taper tantrum.” Though many investors fear the rising rates will erode their investment yields, they must consider the strength and durability of the current economic cycle and how it will continue to support commercial real estate performance. First-quarter job creation outpaced the growth rate of the past three years, while unemployment has been restrained to exceptionally low levels. Additionally, over 6 million jobs remain available, highlighting the tight labor market and the skills gap facing employers. Healthy economic momentum has driven both consumer and business confidence to extraordinarily high levels, with consumer optimism nearing an 18-year high in April. Rising confidence trends reinforce indications that consumption and business spending will rise this year, boding well for housing and all types of commercial real estate space.

Sub-3 percent 10-year Treasury rates were an anomaly; Fed carefully considers rate increases. From a long-term perspective, the 10-year Treasury has averaged 6.2 percent, and until the post-recession era, it had never been below 3 percent for a prolonged period. In the midst of the Great Recession, the Fed put strong downward pressure on interest rates to spark economic growth, lowering the Fed funds rate to near zero and launching a series of quantitative easing efforts. Rates have remained low since then, but the accelerating economy has prompted the Federal Reserve to hedge against the potential of economic overheat by raising the Fed funds rate and reducing their balance sheet. It is likely the Fed will maintain a cautious approach so it does not inadvertently cause the economy to stall, but it has indicated that it may raise rates three or four times in 2018. Even with the increases, interest rates remain very low by historical standards and should not be a major barrier for real estate investors.

A rapid interest rate increase could create turbulence for commercial real estate transactions. Rising interest rates will lift the cost of capital for borrowers, modestly eroding margins and forcing buyers to re-underwrite acquisitions. Though competition among lenders may prompt some to narrow their spreads, absorbing a portion of the cost increases, a very rapid rise in rates could create a short-term stall in transactions. This reflects a widening expectation gap between buyers and sellers as buyers reevaluate their margins and sellers continue to seek premium pricing. Eighteen months ago, when interest rates escalated 85 basis points in a month, numerous transactions faced renegotiation, delaying closings.