Upward pressure on cap rates is expected, muted by strong capital flows from foreign and domestic institutional investors. CRE fundamentals remain strong overall, and improved business and consumer confidence may lead to enhanced late-cycle tenant demand.

• The Fed raised interest rates by 25 basis points and is poised to make two additional rate hikes this year.
• Upward pressure on cap rates is expected, though it will be muted by strong capital flows from foreign and domestic institutional investors.
• The cost of debt capital is increasing with the underlying indexes, but the accessibility of deep and diverse capital sources should mute the impact, as spreads have narrowed slightly from pre-election levels.
• While there are some signs of softening in certain Class A multifamily and CBD office markets, commercial real estate fundamentals remain strong overall, and improved business and consumer confidence may lead to enhanced late-cycle tenant demand.

The Federal Reserve raised interest rates by 25 basis points (bps) on Wednesday, lifting the target range for the federal funds rate to between 0.75% and 1%. This is its first policy move of 2017. The Federal Open Market Committee (FOMC) expects to make two additional increases this year, following a single 25-bps increase during each of the past two years. Its decision to accelerate interest rate increases comes amid an improving economy—evidenced by strong job growth, enthusiastic consumer^[1] and business^[2] sentiment, and firming inflation. Commercial real estate fundamentals are similarly strong, and improved economic growth may lead to an extended cycle.

Because this move by the Fed was well telegraphed, there will not be a knee-jerk reaction in the capital markets. On the debt side, credit spreads have remained narrow despite the increasing cost of capital, thanks to deep and diverse sources of capital. Nonetheless, cap rates will increase as the Fed continues to raise rates. Strong capital flows into commercial real estate—particularly from foreign and domestic institutional sources—are likely to mute the magnitude and the pace of the adjustment, however.^[3] Cap-rate increases will be further mitigated if the stimulative growth policies of the Trump administration live up to expectations. There are also downside risks: Any market shock that caused an unexpected withdrawal of capital while the Fed is raising rates might lead to a spike in cap rates, especially in secondary and tertiary markets.

No one should have been caught off guard by this interest rate move, as Fed officials did a good job of communicating their intentions in recent weeks. If their words were not convincing enough, February’s employment report exceeded expectations with a healthy gain of 235,000 jobs. Wall Street was all-in on a rate hike, as Fed funds futures indicated a 95% probability of an increase prior to the meeting.

FOMC members are split on how quickly they want to continue tightening. The median projection is for two more hikes this year, but several key FOMC members have indicated they might want more. This accords with the Fed's shifting posture—we are hearing less about letting the economy “run hot” and more concern about falling behind the curve on inflation.

It will be interesting to see whether the Fed turns more hawkish in coming months. Wage and inflation data will be particularly influential, as will legislative progress on fiscal policy. Setbacks in proposed tax cuts and infrastructure spending, which are supposed to spur economic activity and faster inflation, would allow the Fed to take its foot off the gas.

The bond market appears prepared for fiscal stimulus and higher inflation. Treasury yields have been bid up more than 70 bps since Election Day, giving the Fed plenty of room to raise short-term rates without worrying about inverting the yield curve. While higher rates will make credit more expensive for consumers and businesses in the short term, it will have the positive side effect of giving the Fed some breathing room to lower rates when the next recession hits.

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