One of the most highly anticipated FOMC meetings occurred in September based on the market’s anticipation that the Fed would announce the beginning of “tapering.” The Fed’s announcement to hold off tapering has created significant ripples throughout the financial community. However, we’re seeing some net positives for the REIT industry over the medium term.

Where the Fed started

First, for background to help put current events into context, tapering is the inevitable action the Fed will have to take to withdraw the stimulus it has injected into the capital market. This stimulus consists of acquiring $85 billion per month in U.S. Treasury bonds and mortgage-backed securities. By committing to this large and consistent amount of purchases, the Fed has skewed the equilibrium of supply and demand because it has artificially added demand over the past five years to keep interest rates low.

It’s important to note that the perception of future supply and demand is a greater driver of interest rates than actual supply and demand. The reason that the Fed’s stimulus has successfully kept rates lower is not because of its actual purchases, but the perception by the market that the purchases will continue.

That perception changed dramatically in June with Ben Bernanke’s comments, which focused the market’s attention on the upcoming September FOMC meeting. Bernanke created the perception he would announce tapering, which would spur the removal of the stimulus. As a result, interest rates rose significantly with U.S. Treasury 10-year yields moving 38 percent from mid-June to early September.

That perception changed again when the Fed did not announce tapering last month because it wants to see more consistent strength in economic indicators to show the country has the stability to continue growing out of the recession. Chairman Bernanke stated during the FOMC meeting, “But in evaluating whether a modest reduction in the pace of asset purchases would be appropriate at this meeting, however, the Committee concluded that the economic data do not yet provide sufficient confirmation of its baseline outlook to warrant such a reduction.” Interest rates subsequently declined based on the perception that tapering will be postponed.

Interest rate volatility to come

So what does this mean for rates going forward? In the short term, rates will remain lower than they would have if the Fed had announced the beginning of tapering. But because the Fed has not announced a clear exit plan for its stimulus, volatility will be higher. Given rate movement is based on the perception of the market, and market perception is more fluid without a stated exit plan by the Fed, increased interest rate volatility will result.

Others will argue that the Fed has stated an exit plan tied to economic indicators, and thus the market can rationally adjust its tapering expectation based on these economic indicators. The concern with this position is that there are many economic indicators being re-adjusted, making it difficult to determine which outputs will have the most impact on the Fed’s decision and how to interpret those outputs.

The bottom line is that the market’s expectation is based on supposition and not fact. In today’s world where financial news is updated every minute and often sensationalized, the power of this supposition accentuates volatility. To complicate matters, Congress is creating macroeconomic uncertainties with its inability to come to an agreement on government funding, which can lead to negative implications for GDP. This uncertainty will further support volatility in the short term as it creates another variable shaping the market’s interpretation of the Fed’s timeline for tapering.

In the medium term, the Fed’s announcement simply pushes out the timing of rates rising, which is inevitable given the Fed’s stimulus was never meant to be permanent. When you remove the artificial demand, the equilibrium must shift to a higher interest rate point.

REITs could see improved strength

As I mentioned, the Fed’s announcement will keep rates lower in the short term with an increase in volatility, and pushes out the time table for rates to rise in the medium term. This news has two major implications for REITs.

1. Increased volatility is relative. Volatility is only a bad thing if it’s to such a degree that markets cannot function normally. Rates have been volatile since Bernanke’s June announcement and will likely remain so in the short term. But if you look at the debt markets over the last three months, all aspects of the capital markets have remained open and available for creditworthy entities to tap.

On the secured side of real estate, CMBS issuance has remained vibrant (nearly $9 billion will be securitized in September alone) with limited volatility in spreads (CMBS AAA spreads peaked at just above 120 bps in June, but have since tightened back to around 100 bps for the most recent new issuance).

Life insurance companies remain active, and if anything, have increased their allocations modestly for the remainder of the year. Banks have an enormous need to put out money based on the large amount of deposits they have and are eager to extend capital.

On the unsecured side, there is no better example of a functioning market than its ability to digest the largest single issuance ever -- Verizon’s $49 billion offering on Sept. 11.

2. The inevitability that rates will rise is NOT a bad thing. In fact, everyone in real estate should look forward to increased rates. This might sound counter-intuitive given real estate’s reliance on debt’s stable income profile. But increased rates are positive for several reasons.

First, if rates rise, it’s because the market perceives that the Fed’s stimulus is no longer needed. And that hinges on the economy improving. An improving economy is great news for real estate and the retail sector in particular, because economic strength helps boost retailer performance, create more retailer demand, improve occupancy, and drive higher rents.

Secondly, in the universe of real estate owners, REITs are typically more lowly levered vehicles. An increasing interest rate environment has a more muted impact given the smaller component of debt in the capital stack.

In summary, the Fed’s lack of a clear exit plan for its stimulus (tapering), coupled with uncertainty created by Congress over funding the government, will create more interest rate volatility in the short term. In the medium term, interest rates will inevitably rise once the Fed’s stimulus is removed. But increasing interest rates are not a negative for retail real estate, as they mean a stronger, growing economy. In particular, growing rates have even less impact on REITs given their typically lower leveraged capital structures.

  • CATEGORY: General
  • DATE: Wednesday, October 16, 2013