Waiting for Dramatically Lower Interest Rates Is a Mistake

At its most recent meeting, the Federal Reserve held interest rates steady. At the same time, markets have been focused on the announcement that when Jerome Powell’s term as Fed chair expires later this year, he will be succeeded by Kevin Warsh — a former Federal Reserve governor who has been openly critical of Powell’s approach to monetary policy.

That shift has fueled speculation that a Warsh-led Fed will usher in meaningfully lower interest rates. In commercial real estate circles, this has reinforced a widely held belief: That investors should wait for rates to drop sharply before becoming active again, and that potential sellers should hold off until declining rates push asset values materially higher.

I believe that perspective is misguided.

In commercial real estate, the most important benchmark is not the federal funds rate, but the 10-Year U.S. Treasury. Most permanent financing — whether bank, life company or commercial mortgage-backed securities — is ultimately priced off that instrument. While short-term rate policy matters at the margin, long-term Treasury yields reflect inflation expectations, fiscal discipline (or lack thereof), global capital flows, and risk premiums that extend well beyond who occupies the Fed chair. (It should also be noted that cap rates, which are reflective of property values, are more highly correlated to capital flows as opposed to interest rates. But that is a column for another day.)

The idea that the 10-Year Treasury is poised to fall dramatically — and stay there — is inconsistent with both history and current macroeconomic realities.

Over the past 50 years, the average yield on the 10-Year Treasury has been approximately 5.4 percent. Today, we remain well below that long-term average. That alone should give market participants pause. The ultra-low rate environment that defined much of the period following the Global Financial Crisis was not normal. It was the product of extraordinary monetary intervention, repeated quantitative easing, and a global flight to safety that persisted far longer than many expected.

We lived through a period where rates were far too low for far too long, and that environment lulled many commercial real estate participants into a false sense that low rates were a permanent feature of the landscape. They were not. They were an anomaly.

Unless we experience a severe global financial calamity — a crisis that forces central banks worldwide back into emergency mode — there is little reason to believe long-term rates will collapse meaningfully from here. Inflation is moderating, and growth may slow at times, but the structural forces pushing rates higher are powerful: persistent fiscal deficits, elevated government debt, geopolitical instability, and the reshoring of supply chains, all of which are inflationary at the margin. 

Recent GDP growth has been positive and, based on the massive investments that foreign governments and companies have pledged to deploy into the U.S. (which doesn’t happen overnight), the future of the economy looks very positive. 

Yes, under Kevin Warsh, we may see a Federal Reserve that is marginally more growth-oriented and somewhat less inclined to maintain restrictive policy for extended periods. That could translate into modestly lower rates over time. But “modestly lower” does not mean a return to 2 percent Treasurys or 3 percent mortgage coupons. Those levels were historically aberrant, and decisions should not be built around the assumption that they will reappear.

This has important implications for commercial real estate values and volumes moving forward.

For buyers, waiting on the sidelines for dramatically cheaper debt may mean missing the very opportunities that emerge in transitional markets. 

I believe that in New York City today, we are looking at the best buying opportunity of a generation. I no longer say the best opportunities were during the savings and loan crisis in the early 1990s, they are right now. Pricing adjusts faster than sentiment. As sellers recalibrate expectations and capital constraints force transactions, opportunities arise — not when rates collapse, but when participants accept reality.

For potential sellers, delaying in the hope that falling rates will magically restore peak 2015 valuations is equally risky. Asset values are a function of income durability, capital structure and investor confidence and capital flows, not just rates. In many cases, clarity and liquidity today may be preferable to uncertainty tomorrow.

Markets do not require “perfect” interest rate environments to function. They require alignment between buyers and sellers, transparency around risk, and realistic underwriting assumptions. The sooner participants internalize that the post-GFC rate regime is unlikely to return, the sooner transaction velocity can normalize.

At BKREA, we have always believed that the best decisions are made by grounding strategy in long-term data, not short-term hope. Interest rates may edge lower over time. But they are not going to fall massively absent a true global shock, and building a business plan around that assumption is not prudent.

The market will move forward. The only question is who will be prepared when it does.

Robert Knakal is founder, chairman and CEO of BK Real Estate Advisors.