Federal Reserve interest rate cuts may help turn the tide for commercial real estate. Yet investors should tread carefully if they’re wading into the market. Central bank policymakers’ half-point reduction last month “marks the beginning of the end of the worst CRE downturn since the Global Financial Crisis,” Wells Fargo said in a Sept. 25 note. “Lower interest rates are not a magic bullet, but less restrictive monetary policy lays the groundwork for a commercial real estate recovery,” wrote senior economist Charlie Dougherty. “Decreased long-term interest rates appear to be easing upward pressure on cap rates and slowing declines in property valuations. Meanwhile, increased expectations for an economic soft-landing look to be giving capital the green-light to move off the sidelines,” he added. There are some bumps in the road. On Monday, the 10-year Treasury yield rose above 4% for the first time since August, following Friday’s better-than-expected jobs report . Bond yields move inversely to prices. One basis point equals 0.01%. Fed funds futures trading suggests a roughly 84% likelihood of a quarter-point rate cut at the next Fed meeting in November, while no one is expecting another half-point cut, according to the CME FedWatch Tool. Of course, there is no shortage of obstacles ahead for the market, particularly for office space, Dougherty said. “That said, reduced interest rates should prevent distress from spreading and shorten the hurdles coming down the road,” he added. Lower refi rates for borrowers Companies, who had been extending mortgage deals through the higher-rate environment, will see some relief and eventually be able to refinance at lower rates, said Douglas Gimple, senior portfolio specialist at Diamond Hill. His firm’s Short Duration Securitized Bond Fund (DHEIX) has about 25% of its portfolio in non-agency commercial mortgage-backed securities, as of Sept. 30. DHEIX YTD mountain Short Duration Securitized Bond Fund year to date “It’s not a cure all,” Gimple said. “It’s not going to happen overnight, as we know that when the Fed takes action — whether higher or lower — it takes a while for it to work its way through the system.” He thinks investors can find value now by focusing on a bottom-up process. “If you can find the diamonds in the rough that have been hurt from a pricing standpoint because of their association with commercial real estate, then you can find some really good opportunities,” he said. “You just have to be cautious.” Know what you’re buying Investors should understand what their managers are buying or if they are investing themselves, understand what they are purchasing, he said. Gimple specifically likes single-asset, single-borrower CMBS and commercial real estate collateralized loan obligations. The former, as the name implies, involves one asset — like a high-end hotel — or a single borrower, which can be a hotel chain with multiple locations. The latter are shorter-term deals that are floating-rate and are usually taken out by a company to upgrade a property, like putting in a pool or energy-efficient air conditioning into an apartment complex, he said. Each investment will also always be deal dependent, Gimple said. For instance, he isn’t buying office space in Los Angeles or New York, but may look at a suburban deal. He would look at offices that are class A, which are typically the most modern, and have a 95% occupancy rate with a diversity of occupants. Within hotels or lodging, he looks at “trophy” properties in areas like Miami or Hawaii. “It’s not really about the hotel, it’s about the location,” Gimple said. He also looks at single family rental and industrials, as well as retail to a certain degree. Any CMBS holdings should be just part of a diversified fixed-income portfolio that includes credit and Treasurys, he said. “It depends on the risk appetite that’s going to determine what kind of allocation they should be looking at,” Gimple noted. “You’re remiss as an investor if you’re just avoiding an entire part of the market because you read the headlines. There’s still opportunities there.”
