The Federal Reserve has shifted its monetary policy, announcing in their eagerly anticipated September meeting a 50-basis point rate reduction of the benchmark federal funds rate, marking the first cut since March 2020, and concluding the most aggressive monetary tightening cycle in decades. With economic data signaling steady progress in the Fed’s inflation fight toward their 2% target, the focus turns to preserving a still solid labor market showing signs of cooling.
Perhaps, as significant as this initial cut is the path the Fed sees going forward. The Fed dot plot, a quarterly updated chart that tracks each Fed official’s forecast anticipates lowering the key benchmark interest rate to 3.25-3.5 percent. Prior to last week it stood at 5.25-5.50, which indicates a 200-basis point decline in under 18 months.
With an easing cycle having begun, investors may ask:
In principle, more favorable financing with lower borrowing costs translates to greater demand, potentially higher levered yields on investment, a more competitive market, and consequently rising property values. While there are, of course, numerous variables that dictate a property’s valuation, the conventional real estate wisdom and historical tendency is that interest rates and CAP rates have a direct correlation. In other words, when interest rates fall, capitalization (cap) rates follow.
[Cap rates are calculated as the ratio of a property’s net income to its current market value. Cap Rate = Property Value/Net Operating Income (NOI).]
For current real estate owners, including owners of DST properties, a declining interest rate and compressing cap rate environment bodes well for asset appreciation. In simple terms, with NOI constant, a lower cap rate yields a higher property value. Growing NOI, of course, further drives value. Consequently, even when other factors remain constant, when interest rates fall, real estate prices rise.
On the matter of NOI growth, some assets in certain markets, namely among multifamily, have come under stress with inflation-driven expense growth and declines in occupancy and rent growth due to a surge of new supply. However, a result of higher interest rates in this recent monetary cycle is the lagging effect of new development, which may present a favorable outlook for current investors. Higher borrowing costs have resulted in a sharp decline in new construction starts, dramatically reducing future supply. This projects out to increased demand, occupancy, and rent growth for existing assets, having in view the chronic national housing shortage (estimates put the undersupply of housing at between 3-5 million units). Furthermore, if the Fed has indeed accomplished its goal of stabilizing prices, property expenses may look to settle back to historic norms. In short, revenues outpacing expenses equate to growing NOI, which when applied to lower cap rates (induced by an interest rate declining environment) reveals an encouraging near-to-medium term outlook for current investors.
Long term net-leased properties, while not subject to the same NOI fluctuations (negatively or positively) as multifamily or other shorter-term lease asset classes, will also stand to benefit from cap rate compression in an interest rate declining environment.
The counteracting matter of the overall health of the economy should not be left out of the equation. A large initial rate cut may be interpreted as an emergency response to weakening economic conditions. However, to that point, Fed chairman Jerome Powell points to continued solid growth, a still solid labor market, and inflation nearing its target, stating that this cut is a recalibration of central bank policy which, in hindsight, could have already begun with a cut in the Fed July meeting. It remains to be seen whether the Fed has achieved the elusive soft landing (despite downward trends in leading indicators such as manufacturing and transportation), but the macroeconomic picture today may lend greater confidence to that outcome than before.
Many traditional investment property owners who have sought to sell their properties and conduct 1031 exchanges, including into DSTs, have met the expected challenges transacting in a high-interest rate environment. With the Fed path now clearer, prospective DST exchange investors may find a more favorable seller’s market ahead. Additionally, with more recently syndicated DSTs being bought at expanded cap rates, it may be an opportune time for sellers to capitalize on a market already pricing in future rate cuts while exchanging into DST properties at an attractive basis.
With the Fed beginning its interest-rate easing, the high yields investors have enjoyed in money-market funds, certificates of deposits, and high yield savings accounts are likely in decline. Investors may soon look to take their cash off the sidelines to transfer to more competitive investments for income. Alternative real estate-based investments, such as private real estate funds and private REITs, may offer an attractive destination, particularly with the tax advantages unique to real estate, offering shelter from income tax and greater net effective yield. One such current example is the Capital Square Housing Trust Preferred Stock Offering yielding 9% annually, presenting investors an option to lock in a competitive rate even as cash yields decline.