Analysis: 10-year Treasury moves into focus ahead of Federal Reserve meeting

The Federal Reserve has not changed the target rate, which has stood at a level of 5.25-5.5 percent, since July.

Commercial real estate executives are not expecting to see the Federal Reserve cut interest rates at their meeting January 31, with several lenders and investors telling Real Estate Capital USA the outlook for the 10-year Treasury has become more important to the market than the federal funds target rate.

The Federal Reserve has not changed the target rate, which has stood at a level of 5.25-5.5 percent, since July. While the central bank has indicated the potential for rate cuts in 2024, the timing is not as important as what happens in the near-term with the 10-year Treasury, according to Ali Meli, founder of private credit manager Monachil Capital Partners based in Greenwich, Connecticut.

“How much of cashflows and NOI generated by a property needs to go towards covering cost of debt and how much cashflow is available to go to equity, and at what rate equity cashflows are discounted, are all tied to the 10-year Treasury,” Meli said. “That is where the game is played.

“Where the Treasury department will be issuing 10-year bonds or how much is being sold is also far more important than whether the first cut will be in March, May or June and where the 10-year Treasury is trading [January 31] at 4:00 will be critical.”

According to data from Chatham Financial, an advisory firm based in Kennett Square, Pennsylvania, the 10-year Treasury stood at 4.07 percent on January 30, significantly higher than the 3.54 percent seen one year ago.

Michael Lee, a partner at New York-based advisory HKS Real Estate Advisors, believes the market is grappling with bigger questions than the potential for a rate cut.

“Everyone has been laser-focused on the Federal Reserve over the past two years, but the bigger question is: if rates don’t change, or even if they do, what are properties worth?” Lee said.

The firm is seeing more clients who are thinking about refinancing or selling but are constrained by a lack of clarity around valuations.

“If rates are cut quickly and go back down to 4 percent, a valuation from 2019 may still look good. But if the Fed takes rates down slowly over several years, operators may be forced to take a significant discount driven by their loan maturity date,” Lee added. 

Outlook

The commercial real estate market today can be roughly split into three categories: non-performing, performing or properties that are on the cusp because of near-term refinancings, Meli said.

For some assets, particularly those in the office sector, the issues are larger than what is going on with rates.

“There are also problems with regard to operating cashflows,” Meli said. “The question then becomes, is there enough operating income to justify any valuation, regardless of the rate. That sector of commercial real estate will continue to have its challenges and capital structures will need to be restructured and repriced. Essentially, there are impairments in those assets no matter what the Fed’s rate policies are.”

Meli cited other properties that are directly sensitive to rates, including those in the apartment, industrial and grocery-anchored retail sectors. “These assets will be impacted by the Federal Reserve’s commentary,” he added.

Particular attention should be paid to the Federal Reserve’s commentary around quantitative tightening measures and the potential shrinking of its balance sheet, Meli added.

“If the Federal Reserve continues to shrink its balance sheet that will, at some point, affect the banks which otherwise might have been lending in the commercial real estate sector. If the Federal Reserve signals less support for the Treasury market, the incremental supply of long-term Treasuries will fall and that will reduce balance sheet available for commercial real estate lending,” Meli said.