Interest Rates and Commercial Real Estate By Robert Hand

Transcription

1 Interest Rates and Commercial Real Estate By Robert Hand When you hear on TV that the Fed moved rates lower today, the anchorperson is attempting to share news that will help you, but actually the news presentation can be misleading. What the anchorperson fails to explain is that there is no single interest rate, and this article intends to clear up the confusion. Understanding interest rates is not just for Wall Street bond traders; with a little knowledge about how interest rates move, you can make smarter decisions about buying commercial real estate. Interest rates are an important way to control the economy; high interest rates can be instrumental in curbing the effects of inflation which erode your purchasing power, while low interest rates can stimulate the economy, mainly through growth in jobs and income. It is the mission of the Federal Reserve to regulate interest rates in order to control inflation or boost the economy, but it is important to note they control only two types of interest rates: the federal funds rate and the discount rate. First let s examine what the Federal Reserve is and then we ll look at the different types of interest rates. The Federal Reserve was established by Congress in 1914 and is divided into four components: Seven Board of Governors who determine and set the nation s monetary policy. A twelve member Federal Open Market Committee (FOMC) that sets one interest rate called the federal funds rate. Twelve regional national banks spread throughout the United States. Economists who provide reports for the government and citizens. Each month, the Federal Reserve Board meets to discuss the specific target levels for the federal funds rate, or the rate at which banks borrow money overnight among themselves. It is one of many interest rates. Think of an interest rate as the cost of money, or the intersection of the demand for money and the supply of money; however, there is always a specific maturity for each interest rate, such as: Fed funds are usually for an overnight period CD s are usually one month to five years Treasury bills are usually one to six months Treasury notes are usually five to ten years Treasury bonds are usually ten to thirty years So when you hear on the news that the Fed raised rates, remember they only changed either the fed funds rate or the discount rate. Over the long term, the financial market, not the Federal Reserve, sets the interest rate for other investments. C:\remax\web site\newsletters\interest Rates Article final.doc Page 1 of 6

2 Definition of the Federal Funds Rate The interest rate you hear on the news the most is the federal funds rate, which is the rate at which a bank with excess reserves loans money to a bank that needs reserves. To buy and sell in the fed funds market, you must be a commercial bank and a member of the Federal Reserve System. Most of this borrowing is done on an overnight basis, so this rate rarely affects the rate of money loaned to you for one to five years because of the difference in maturities. Today, the fed funds rate is 1.88%. Chart One: Fed Funds Rate Between 1952 and 2007 Discount Rate The discount rate refers to the interest rate that lending institutions will be charged when borrowing money from the Federal Reserve. Today the discount rate is 2.25% for primary credit to sound banks. The rate exceeds the fed funds rate, encouraging banks to use the discount window only as a back-up to the fed funds rate. A bank also must post collateral before borrowing from the discount window. Mortgage Rates and the Fed Funds Rate Mortgage rates are usually for 30 year periods and are not set by the Federal Reserve Board, but by the supply and demand for 30 year money. The demand comes from individuals like you and me who want to buy a home, and supply comes from investors with cash to invest with expectations of getting a certain level of income for a 30 year period. Mortgage rates have to compete with Treasury Bond rates and Corporate Bond rates to attract investors. In the long run, what drives interest rates is the expectation of inflation, because as inflation erodes the future value of your money, you will need a higher current interest to compensate for that loss. C:\remax\web site\newsletters\interest Rates Article final.doc Page 2 of 6

3 Understanding the Prime Rate The Prime Rate is the interest rate that lending institutions offer their best credit worthy customers. This is the rate that you will most commonly see associated with short-term financing of commercial real estate transactions. Today the prime rate is 5.25%. Chart Two: The Prime Rate Over the Past 10 Years Credit Card Rates Credit card rates have little to do with mortgage rates since there is no asset like a home backing a credit card. Credit card companies usually charge a fee to the merchant of 1.75% of the amount you charge. This fee is in exchange for immediately paying the merchant versus the risk the credit card company incurs in collecting the money from you at the end of the month. States have Usury laws which set a ceiling on the interest rate a credit card company can charge. Today, most credit card interest rates are at least 18%. C:\remax\web site\newsletters\interest Rates Article final.doc Page 3 of 6

4 Table One: How Various Interest Rates Have Changed Over The Past Year May 15, Year Ago Federal Funds rate 1.88% 5.25% Discount rate 2.25% 5.86% CD rate-1 month average 2.52% 5.23% CD rate-3 month average 2.62% 5.27% CD rate-6 month average 2.77% 5.23% Prime rate 5.00% 8.05% Treasury Bill rate-4 week 1.70% 4.32% Treasury Bill rate-12 week 1.74% 4.36% Treasury Bill rate-24 week 1.83% 4.44% Treasury note rate-1 year 2.01% 4.53% Treasury note rate-2 year 2.30% 4.36% Treasury note rate-3 year 2.54% 4.35% Treasury note rate-5 year 3.00% 4.43% Treasury note rate-7 year 3.34% 4.51% Treasury note rate-10 year 3.78% 4.63% Treasury bond rate-20 year 4.52% 4.91% Treasury bond rate-30 year 4.53% 4.84% Corporate Bond Aaa rate 5.49% 5.56% Mortgage rate 6.05% 6.34% Source: Chart Three: How Various Interest Rates Have Changed Over The Past Year C:\remax\web site\newsletters\interest Rates Article final.doc Page 4 of 6

5 Each of these interest rate types listed in Table One and illustrated in Chart Three have shown decreases over the past year, but short-term rates have fallen more than long-term rates. This illustrates the impact the Federal Reserve has on short term rates and also their ineffectiveness at controlling long-term rates, which have remained high because of expectations of inflation. Strangely enough, high inflation bodes well for real estate values, as in the table below. Table Two: Annual Rates of Return of Various Investments During High Inflation Periods Inflation Period Inflation Rate Stocks Bonds Real Estate Land Silver % 11.60% 2.10% 17.50% 14.70% 15.50% % 12.30% 2.60% 12.20% 18.50% 8.60% % 24.80% 0.90% 10.20% 21.70% 20.50% % 6.40% 6.10% 10.30% 12.70% 23.70% % 5.80% 3.80% 10.30% 14.60% 21.50% Source: Investment Analysis and Portfolio Management, Cohen, Zinbarg and Zeikel How does this affect the commercial real estate? While interest rates can certainly affect the economy, they generally do so slowly. When rates rise, we borrow less since we have to pay higher interest rates, resulting in an overall slowing of the economy, with fewer home purchases, fewer car purchases, and less consumer spending than in a lower interest rate market. The opposite occurs when interest rates fall; businesses will borrow to buy inventory to grow and consumers will borrow to buy homes and cars, creating a multiplier effect therefore causing growth in the economy. That economic growth is the driver for growth in commercial real estate values. The Yield Curve- How Does It Indicate a Recession? The yield curve plots interest rates against various maturities, usually a 3 month, 2 year, 5 year, and 30 year US Treasury debt. Some economists look to the yield curve to predict the state of the US economy and the potential for a booming stock market or a recession, and there is no reason you can t predict the economy too. Here s how. There are three primary yield curve shapes: normal, flat and inverted. A normal yield curve occurs when long term bonds have a higher yield than short term bonds, illustrated by a slope of the yield curve at a 45 degree curve. In this situation, there is a growing economy and inflation is under control. The long term trend of the stock market is up. A flat yield curve exists during stagnant economic growth with no incentive to invest for long term because short term rates pay just as well. An inverted yield occurs when short term yields are higher than long term yields, and is typically viewed by economists as a sign of an upcoming recession. C:\remax\web site\newsletters\interest Rates Article final.doc Page 5 of 6

6 Chart Four: Yield Curves Normal Flat Inverted Inverted yields affect both investors and consumers. When short term rates are higher than long term interest rates, it is usually a result of tightening by the Federal Reserve to stave off inflation by slowing down an overheating economy. If rates stay high for long, the economy can slow more than expected and can enter a recession. Typically the Federal Reserve tightens too much and also loosens too much. The negative result of tightening interest rates to reduce inflation is higher unemployment, putting people out of work. Eventually rates should fall, so when the yield curve is inverted, invest in 30 year Treasury Bonds- because as rates fall, the value of the bond will rise in market value 7% for every 1% drop in rates, in addition to the coupon interest you earn. The time to invest in commercial real estate or stocks is after the Fed starts to drop interest rates which would cause the inverted yield curve to return to its normal 45 degree curve. C:\remax\web site\newsletters\interest Rates Article final.doc Page 6 of 6