Fed Tapering = REIT Returns Tapering or More?
Posted by Surabhi Sheth, Real Estate research leader, Deloitte Services LP, on February 05, 2013
We closed out 2013 with some finality to the buzz around the Federal Reserve’s much anticipated tapering of its quantitative easing program, popularly known as QE. The salient features of the wind-down plan announced December 18 include:
- Beginning January 2014, the Fed will reduce asset purchases, the quantity of which will be determined on a monthly basis. For January, the Fed announced a $10 billion reduction, evenly split between Treasuries and agency mortgaged-backed securities (MBS). Until December 2013, the Fed purchased $45 billion and $40 billion of Treasuries and agency MBS, respectively, on a monthly basis.
- Interest rates will remain low well past the point that unemployment is 6.5 percent and below and inflation is lower than the Fed’s long-term 2 percent target rate.
Since interest rates are an important factor in the commercial real estate (CRE) industry, there is bound to be an impact. The question is, how big an effect will there be?
A lot of pre-emption and speculation about the timing of the tapering had already gone into the run-up to the Fed’s December 2013 announcement. Result: The potential impact of such an action had already been priced by the markets. Interest rates and the S&P 500 rose between May and December. Consequently, we saw no significant change to either interest rates or the stock market soon after the announcement and only a continuation of the trend.
What does the Fed tapering mean for the broader economy? To some extent, the tapering signals confidence in the economic recovery. The CRE recovery tends to lag the broader economic recovery by six months. Hence, if the Fed tapering is considered an indication of a sustained economic recovery, the CRE industry should follow suit. That said, what is the current state of the CRE industry?
As mentioned in our 2014 CRE Outlook, the industry continues to grow at a moderate pace, marked by continued recovery in asset prices, transactions and capital availability. Fundamentals – rents and occupancy – have strengthened since the economic downturn and are now stabilized across property types. Development activity, however, remains muted for most property types.
So, what effect might the Fed’s tapering of QE likely have on the CRE industry? We believe the impact will be most evident in:
- Mortgage originations
- REIT returns
- Asset prices and cap rates
First, let’s look at the impact of the tapering on mortgage originations. While the Fed’s comments indicate that the benchmark rate will remain low in the near-to-medium term, mortgage rates have risen 92 basis points (bps) between May and December and 110 bps in 2013.1 This has already affected mortgage originations and particularly refinancing activity, which have slowed down. While we expect this to be only temporary and believe the market will eventually settle down as interest rates are still quite low, we remain cautious about its impact on cost of financing and the fragile housing recovery.
Next up, REIT returns. REITs as an asset class have had to face the heat even in the run up to the Fed tapering through 2013. REITs underperformed traditional asset classes in 2013 - with returns of 3.2 percent in 2013, compared to 32.4 percent and 38.3 percent returns of the S&P 500 and Russell 2000, respectively. In contrast, during and post the 2008 economic crisis, investors chased REITs for yields, following which they outperformed the S&P 500 and Russell 2000. However, with the rise in interest rates, REITs have fallen out of favor with investors. Historically though, REIT performance and CRE values have improved during periods of rising interest rates and a strengthening economy. During the six monetary tightening cycles since 1979, when U.S. treasury yields rose significantly, REITs generated cumulative returns of 56.5 percent, compared to 38.3 percent returns on stocks and 4.2 percent on bonds (Figure below).2
Finally, asset prices and cap rates have firmed up nicely after the financial crisis. Assuming a systematic, paced-out unwind, bond yields are likely to widen. And, with a rise in the Treasury rates, properties with low-cap rates may come under pressure in the near term, especially if NOI growth doesn’t keep pace. The other end of the spectrum that may be impacted are the underperforming and/or distressed assets. As of 3Q13, $105.2 billion (42.1 percent of first three quarters’ transaction volumes aggregating $250 billion) of distressed assets still formed a part of the total inventory.3 Will this spur M&A activity?
So, what’s the bottom line? Keeping the modest CRE recovery in mind, in the short-to-medium term, the Fed tapering will likely act as a damper on mortgage originations and REIT returns.
2Cohen & Steers, “What History Tells Us About Rates, REITS, Inflation and Rising Rates,” Viewpoint, April 2013
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