Look First to Treasury Yields for the Answer
For the past few weeks, we have focused our posts on the beneficial impacts on commercial real estate of the One Big Beautiful Bill Act (OBBBA). Perhaps the most significant of them is the enhanced benefit of utilizing the Cost Segregation methodology for depreciation in combination with the return of 100% Bonus Depreciation rules. Click here to review that post. We believe it is a game changer for the industry and we will be getting back to that topic soon for a deeper dive that will include tools and resources you can use to evaluate the efficacy of cost segregation for you.
But first we turn our attention back onto interest rates, which have been the hot news topic in the weeks leading up to the Fed’s recently completed annual meeting in Jackson, Wyoming. The drama meter has been in the red zone as the president and several of his closest advisors have been ratcheting up the pressure on Fed Chairman Jerome Powell and his Federal Open Market Committee (FOMC) to lower its benchmark Fed Funds Rate, which is the rate member banks charge each other for overnight lending. While it only impacts bank-to-bank lending directly, it is closely watched by everyone in the money lending business as a bellwether for setting rates on other types of loans, whether it be for a car, a credit card or a home equity line of credit. Thus, it has become the holy grail of financial indexes, as it tells the market what direction the so-called experts think the economy is headed. Put another way, it tells the market how to feel about the future. It comes down the very human way of thinking our way into feeling good about big decisions before we pull the trigger.
To move the economic needle, the FOMC uses changes to the Fed Funds Rate to control the flow of capital by adjusting the cost of that capital. When the economy slows, the FOMC lowers the rate to increase the flow of money to stimulate economic growth. When the economy overheats, causing inflation, the FOMC raises the Fed Funds Rate to make capital more expensive, thereby reducing the demand for it, which slows the economy down, easing inflationary pressure. Thus, they use the Fed Funds Rate much in the way we use the throttle and the brake in our car as we drive to work each day. In both instances, it’s about arriving at our destination safely.
Interestingly, a change to the Fed Funds Rate tends to have more significant impact on the short end of the borrowing spectrum. So, if the FOMC raises the Fed Funds rate it tends to have more impact on short term US Treasury Bills yields (4-week to 2-year bills) than on the longer term Treasury notes and bonds (10-year to 30-year). And, it’s treasury yields that are used by lenders as theoretically risk-free benchmarks for developing risk premiums for the loans they make, including commercial property mortgages.
Since commercial mortgages are longer term in nature, risk underwriters use the longer end of the US Treasury Yield Curve as their benchmark to evaluate risk, more specifically the yield on the 10-year Treasury Note. Thus, a change in the Fed Funds Rate may have little or no immediate impact on long term mortgage rates, as the 10-year yield tends to more reflective of the long term economic outlook for inflation, budget deficits and other considerations. Right now, inflation is still well above the Fed’s target of 2% and budget deficits are at record highs and still rising. So, long term bond investors are demanding higher yields to part with their cash, as they see the risk of long term bond investments as increasingly risky. More perceived risk means more risk premium. As a general rule, we add +/- 200 basis points to the 10-year Treasury yield to estimate the rate on a commercial property mortgage. It won’t be exact, but it will be close enough to make an informed decision when estimating borrowing costs.
What does this mean for commercial mortgage rates going forward? Our opinion is: more of the same, even if the FOMC decides to start cutting, and at least until inflation is firmly under control and we turn the corner on multi-trillion-dollar deficits. So, if you are a prospective buyer waiting around for the Fed to save the day on mortgage rates, you may be on the sidelines for longer than you want to be. Fortunately, the multiple benefits of the OBBBA are now in play and the new legislation will help mitigate the higher cost of mortgage capital.
Cost Segregation used in tandem with Bonus Depreciation is the tip of that new spear and we will get back to that topic next week with further details on how it could benefit you in a commercial property acquisition. Stay tuned.