Federal Reserve Impact on Commercial Real Estate and Interpreting the DOT Plot

The Federal Reserve, often referred to as the Fed, is the central bank of the United States which primarily governs Monetary Policy. The Fed manages the country's money supply and interest rates to promote maximum employment, stable prices, and moderate long-term interest rates. Understanding the FED’s impacts is critical for Commercial Real Estate participants as the #1 determinant impacting income producing real estate valuations, is interest rates or the cost of borrowing.  

The FED accomplishes this through their self-imposed dual mandate. In other words, their two ultimate goals that they are looking to accomplish are “full employment” & stable equilibrium inflation, (currently defined as roughly 3.8-4.3% unemployment and 2% inflation, respectively.)

The FED has many tools to accomplish this dual mandate but the primary instrument they use is setting of the Federal Funds Rate (“FFR”),or the interest rate at which banks lend reserve balances to other depository institutions overnight. When the Fed adjusts the federal funds rate, it affects borrowing costs throughout the economy, influencing everything from consumer loans to mortgage rates and business financing. A lower rate generally encourages borrowing and spending, while a higher rate can help cool off an overheating economy by making loans more expensive.

The FED is governed by the Federal Open Market Committee.Much like large companies have board of directors that make decisions, the FOMC is made up of 12 members: the seven board of governors, the president of the regional New York Fed and four other Reserve Bank presidents located throughout the country. The board and the New York Fed president have permanent voting positions, while the four regional bank presidents rotate on and off the board annually.

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Now, to dive into how exactly the FED comes to a decision of where to set the Federal Funds Rate.

• Above is an illustration of a Dot Plot graph. Each Dot represents future expectations of each FOMC members vote for their desired Federal Funds Rate. They vote by placing one dot per member representing their anticipated midpoint in each year over the next few years as well as their long run expectations.

• The concentration of dots can also describe the level of unity between the members of the FOMC. If Dots are widely spread out this indicates is a policy dispute between the members which could lead to more volatility with where the FFR is set, whereas if the Dots are more concentrated, this describes more unity within the FOMC and a higher degree of predictability.

• It is also important to note that the FOMC and the FED decision making is highly data dependent. So, while a higher concentration of Dots in a certain range may represent unity amongst members at one point in time, new data can lead to changes in opinions amongst the FOMC members.

• Averaging these dots can provide an indication of where the FFR policy response will beset. The below table uses summary statistics to represent the central tendency, median and range of the congregated FOMC member dots.

• Thus, it is important to monitor not just the released information each meeting but the changes of expectations between each FED meeting in an attempt to anticipate the FED’s policy response as outlined but the last row of the table representing the FFR and prior period projection.

• Essentially, if the labor market shows signs of deteriorating beyond the FED’s projections in their last policy meeting, they may be more likely to agree on a greater than expected rate cut. Or if inflation is heating up or cooling too fast this could also change the FED’s decision resulting in hikes or cuts.

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How does this relate to commercial real estate values?

As previously mentioned, the Federal Funds Rate impacts practically all borrowing cost. As an investor in commercial real estate we are concerned with the rates at which we can borrow funds to invest. Lenders will typically quote their loan bids for interest rates they are looking for as a spread above the treasuries of the corresponding term. (I.e. If you want a 5-year loan, lenders may quote 250Basis Points above the 5 Year Treasury. Or a 10-Year loan a lender may quote 225 Basis points above the 10 Year Treasury, Etc.)

If the treasuries are high, the interest rates will be high, and investors will demand a higher cap rate to compensate them for a higher borrowing cost. Assets trading at higher cap rates results in reduced commercial real estate valuations.

While the FED does not set Treasury rates, the Federal FundsRate dramatically influences treasuries due to the term risk premium concept effectively stating that investors who invest in bonds will (typically) require a higher return (yield) on the longer dated treasuries to compensate them for the risk associated with having their money invested for an extended period of time.

The more time associated with an investment horizon, the more risk. (For example, if I lent you money for 24 hours, I may require a very small percentage of interest because I view this as low risk. You probably won’t lose your job by tomorrow; you probably won’t get in a car accident, andI will probably get my money back tomorrow. But… if you need a loan for 5 years that is a much longer time period and a lot more could go wrong, so I will need a higher interest rate to compensate myself for that additional risk.)Treasuries typically function the same way. So, when the FED sets the overnight banking rate at 5-5.25% where it currently is set today, this heavily influences the longer dated treasuries such as the 5-, 7-, 10- & 30-year treasuries. Financial theory would state that there should never be an inversion of treasuries yields (when the shorter term yields are higher than the longer term yields for instance the 2 year yield being higher than the 10year yield) but this happens due to anticipation of FED Policy changes.

Thus, Predicting Treasury yields is significantly more complicated as they are more dictated by the expectation of the average yield over the time period of the specific treasuries and overall market fluctuations.  

Historically, in periods of economic stability, the 10 YearTreasury has been about ~100 Basis Points ABOVE the Federal Funds Rate. In the longer run in the above graph, the FED is predicting a 2.5-3.5 FFR which would correlate to a 3.5-4.5% 10 Year Treasury yield. However, today we have a5-5.25% federal funds rate and a 3.691% 10 Year Treasury yield (200 BasisPoints BELOW the Federal Funds Rate.) While this anomaly is likely to be short lived, this clearly demonstrates that markets anticipation that the FED will be reducing rates substantially.

With all that being said, the best practice is typically to take the FED at their word and believe that they will accomplish their long run goals (even though they have a laughably terrible track record) and be ready to adjust accordingly.