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Gauging the effects of the Fed’s interest rate action

Interest rates continue to be at the forefront of every discussion in today’s capital market environment, and we’ve never seen this level of activity in our country’s monetary policy since the Federal Reserve was created. Because commercial real estate is a leveraged asset class, it has a high correlation with interest rates and asset valuation is directly tied to long-term interest rates. Unfortunately, many of today’s borrowers are inaccurately timing refinance and purchase transactions based on misconceptions of how and when the Fed’s policy moves affect interest rates. To better understand the impact of the Fed’s action on the individual owner and his or her bottom line, we must examine the behavior of interest rates at different points of the yield curve.

The yield curve depicts the actual interest rates on the Y axis and their terms on the X axis. It starts with overnight interest rates on the left side of the graph and extends to 30 years on the right side of the curve. The Federal Reserve and the Federal Open Market Committee only control what’s known as the “short end of the curve.” This means the Fed’s monetary policy decides the fate of the Fed Funds Rate, or the typically overnight rate at which the Federal Reserve lends money to banks. This Fed Funds Rate is then extrapolated to form the entire yield curve.

Although any action the Fed takes to regulate short-term interest rates is important, its plans and discussion for future action are also main components in the equation. Let’s look at an example. If the Fed announces it plans to reduce interest rates by 25 basis points and expects to lower interest rates three more times before year end, this news is immediately priced into the market and has an immediate impact on long-term interest rates. As a result, the five- and 10-year Treasuries will already be priced to reflect the Fed’s potential future interest rate cuts.

Here are two simple ways to better understand this complex phenomenon. The first approach is to create a spreadsheet showing the monthly interest rate forecast for the 30-day Fed Funds Rate during the next 60 months and then take the average of those forecasted rates to arrive at today’s five-year U.S. Treasury Rate. This provides the market’s view of where short-term interest rates (or 30-day interest rates) will be during the next five years. We can do the same exercise for 10 years using 120 months of data.

A second way to understand is to look at the stock price of public companies such as Amazon or Walmart. The companies’ current stock prices already take expected future earnings into account – typically forecasting out three or five years. The same goes for interest rates. Any publicly available info concerning where short-term interest rates will land in the foreseeable period is baked into long-term interest rate pricing. The interest rates market is one of the most efficient markets in the world, so all the publicly available information is baked in the rates at any given time.

It’s helpful to understand the difference between short- and long-term rates, to avoid the misconception that when the Fed announces it will lower its rate, a decrease in interest rates will follow. This is not the case, as the three-, five-, seven- and 10-year Treasury rates at which most are borrowing from their bank or financial institution are priced to already reflect potential future Fed rate drops. If the Fed fails to lower rates as previously announced, these same rates actually will increase. This is because the markets had already priced in the Fed’s expected cuts and now need to recalibrate interest rates to reflect the change in plans.

Understanding the relationship between Fed activity and interest rates is critical for business owners borrowing money. The prime and one-month secured overnight financing rates are considered floating rates and are impacted by the Fed’s action. Hotel and commercial real estate owners postponing refinancing or financing a purchase because they think lower rates are eminent after the next Fed cut may have to wait longer or even find themselves in an even higher rate environment. It’s better for real estate owners to hedge interest rate risk when appropriate, and not leave it up to chance to lock in lower rates. Additionally, when long-term interest rates (three-, five-, seven- and 10-year terms) decrease, it indicates the market is expecting a massive negative event, which could potentially trigger a large-scale credit or liquidity crisis.

To better understand interest rate movements and how they affect financing strategies, hotel and commercial real estate owners should consult with an experienced intermediary or investment banker.

rushi shah

Rushi Shah is Principal and CEO of the commercial mortgage and real estate investment banking firm and AAHOA Allied Member Mag Mile Capital. As a leader in hospitality financing, Shah specializes in structuring and placing high leverage, nonrecourse bridge and permanent debt with cash out for full- and limited-service hotels nationwide. Since joining the firm’s predecessor, Aries Capital, in 2015, Shah has structured and closed hundreds of millions in financing for all property types. Shah has held previous positions at Northern Trust and has an MBA from the University of Chicago’s Booth School of Business.



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