Federal Reserve's Influence on Real Estate Investments

By Gibbons, James E. | Real Estate Issues, August 1994 | Go to article overview

Federal Reserve's Influence on Real Estate Investments


Gibbons, James E., Real Estate Issues


The Federal Reserve continues as a hot news item. Everyday newspapers are filled with Fed's latest monetary moves, replete with speculations on what may happen next. TV and radio news broadcasts cover Federal Reserve Chairman Greenspan's reports to Congress and his grilling by supportive and not so supportive legislators, including the Banking Committee chair. President Clinton appears compelled to express mild support for Fed policies; financial markets reflect fear and trembling waiting for the next meeting of the Open Market Committee; developers and mortgage bankers offer public pronouncements about the effects of higher interest rates on the economy. In the center of all this excitement is the Fed.

FEDERAL RESERVE AS INFLATION-FIGHTER

In early February 1994 Federal Reserve lifted the Fed Funds rate target. Fed opined that while inflation was largely under control, it took the step as a preemptive strike to deter a future surge. A similar rate hike was made seven weeks later. Whatever the intent, the results saw an increase in the funds rate from 3.0% to 3.5%, and, to the surprise of many including Fed, during this interval the U.S. Treasury 30-year bond rate moved up from about 6% to aver 7% and mortgage rates rose more than 1%. The two Fed moves, advertised as cutting inflation off at the pass to hold down long-term interest rates, produced an opposite effect; bond prices fell sharply and yields soared. Instead of stabilizing markets, a distinctly bearish atmosphere emerged. The results have shown investors as thoroughly rattled. What does Fed know about inflation that they do not?

The negative attitude is so pronounced that it has spilled over to the equity markets. Real estate also is experiencing a similar sharp run-up of mortgage interest rates, which if they continue, will have to impact industry investment performances and values. Capitalization and discount rates, critical investor considerations, are composite money rates, and as such are market elements influenced by fluctuating capital availability and cost. New and existing residential sales as well as home building may slow down. Such adversity can produce widespread repercussion, since these items have been major props to the recent economic recovery. Thus, Federal Reserve policy and implementation clearly influence real estate and all other economic sectors.

The sensitivity of real estate to financial markets has been enormously heightened by the explosion in securitization of its debt and equity interests. Market makers in these securities often price them to provide expected yields quoted as various basis point spreads above U.S. Treasury yields for like maturities. Thus, changes in items such as mortgage rates which previously might have been slow to transpire, nay occur almost immediately with capital market fluctuations. While many government officials, economists and financial analysts have questioned the wisdom of the Federal Reserve in raising interest rates, no one has questioned the authority and ability of the Fed to do so. What is the precedent for the Federal Reserve to handle its monetary policy missions? How did it attain its present prominence? Hay does it work?

CREATION AND MISSIONS OF FEDERAL RESERVE

As a result of bad depression experiences and money crises over the nation's early years, Congress in 1913 created the Federal Reserve System to be our central bank with the following missions: to be a lender of last resort and to promote orderly growth of our economy. The intent was to prevent further financial crises resulting from unbalanced capital flows throughout the country. When created, the system was divided into 12 districts, each with a reserve bank and all governed by a seven member Board of Governors appointed by the President. Governors have 14-year terms and the chairman is appointed to a four-year term by the President. The Fed, as it is called, is a completely independent body with enormous economic clout. …

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