As expected, the Federal Reserve increased the federal fund rate during its meeting this month by a quarter percentage point to between 0.5 percent and 0.75 percent and indicated that it plans to raise rates three times in 2017 instead of two.
After the increase was announced, Fed Chair Janet Yellen said the move by the central bank should be viewed as a vote of confidence in the U.S. economy, echoing remarks made in November: “With gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will strengthen somewhat further.”
Fortunately, rate changes by the Fed will have a slow-moving impact on hotels and capitalization rates, according to Jack Corgel of CBRE Hotels’ Americas Research and Cornell University.
“The further away you are from the front end of the yield curve, the lower the correlation of rates,” he said. “The rise of the federal fund rate is at very front end of the yield curve and hotel cap rates tend to be further out on the yield curve, if you assume the normal hold is seven to eight years. Interest rates are further out if you’re dealing with a 10-year loan with 25-year amortization.”
Corgel recently released these findings on the relationship between interest rates and cap rates in “The Effect of a Rise in Interest Rates on Hotel Capitalization Rates” in the Cornell Hospitality Report.
Cap-Rate Effect
Jim Costello, SVP of Real Capital Analytics, echoed these sentiments. The first 100 basis points of interest rate increases will be absorbed by the spread between cap rates and interest rates, he said. “After that, they should not move up together in a one-to-one relationship.”
But David Sonnenblick, co-founder and principal of Sonnenblick-Eichner Company, believes that the market may have already taken impending Fed rate increases into account.
“Since the election, interest rates have risen significantly, as much as 50 basis points,” he said. “It is generally believed that the Fed will raise rates at their next meeting, so that increase I don’t believe will have a significant impact on rates as we sit today. We have not seen this recent rise in interest rates having any effect on the availability of capital for real-estate loans.
There is still a tremendous amount of capital available from both Wall Street conduits and on-book lenders, Sonnenblick said. “Borrowers need to remember that we are still in a very attractive interest-rate environment. Real-estate loans today are pricing less than they were 10 years ago, when we thought we were in the most attractive interest-rate environment possible."
Costello said cap rates have been on the way up for the hotel market, but pointed to the volatility of the cap rates in the six major markets of the United States: New York, Los Angeles, Chicago, Dallas, Houston, Washington, D.C. “There has been some increased risk aversion of late on the part of investors for these assets in the six major markets,” he said. “The thinking is that fears of supply are driving that risk aversion.”
Due to the recent increase in interest rates, there should be a slow increase in cap rates over time, during the next six months to 12 months, Sonnenblick said.
“The tremendous availability of equity capital from the international markets competing for deals will help to keep these cap rates down in the short term, even in a rising interest-rate environment,” he said.
Complex System
As Corgel concluded with his study, there isn’t just one factor that impacts hotel cap rates.
“When it comes to cap rates, the general level of interest rates is not the only driver of rates, their risk premiums, that tends to moderate how much change actually occurs; it isn’t just one factor, he said.
From the study, Corgell stated: “Holding other important factors constant, the model estimates that at current levels a 100-basis-point increase in the 10-year U.S. Treasury rate will produce a 28-basis-point uptick in hotel capitalization rates. Continuing improvement in the U.S. economy should eventually result in higher interest rates, but any improvement should also bring both compression of the hotel risk premium and stronger [net operating income] growth, each of which place downward pressure on capitalization rates.”
This finding is supported by broader commercial real estate research. Morgan Stanley, in a white paper, compared the cap rate to a yield for a bond, “or the inverse of a price-earnings multiple in equities.” This would suggest that other key variables could influence cap-rate movements, including credit availability, supply-demand dynamic of space markets and inflation, according to the paper.
“If the increases in interest rates also provide upward pressure for cap rates, and that is still uncertain, will the risk aversion from supply start to fade as the interest rate pressure builds?” Costello considered. “You get that to happen and maybe there is no overall change for hotel cap rates in the six major markets. Or do they compound?”