Fed pause: Loosening monetary policy would be a mistake

Eric Adler April 28, 2023 09:41

It would be reasonable to think real estate investors might welcome the anticipation of financial markets that the Fed will pivot to cut rates later this year.

Rising interest rates have been a leading factor in the declines in commercial property values so far. Ructions amid US regional banks, which play a big part in US commercial real estate lending, will cause further declines.

Meanwhile, a decade of loose monetary policy corresponded with strong inflows to, and returns and value growth for, real estate assets.

But loose monetary policy also led to a damaging period of exuberance when values became unanchored, with insufficient pricing discrimination between property types and lending terms that became too reliant on continued low interest rates to maintain debt service coverage ratios.

The reality is that we are in a downturn and entering a more acute phase characterised by less credit. My optimistic interpretation is that we are in a painful and necessary correction following a decade of central bank largesse which distorted all asset classes, including real estate.

The tightening of credit could tip the US into a recession which has so far remained out of sight. At this stage the preference of most investors would be for a short and shallow recession as the price for lower inflation.

The way this acute phase is playing out should be another cause for measured optimism. Coordination between governments and regulators has been effective. So too has been the way in which US banks stepped in to provide liquidity for First Republic. US banks are showing a proactivity and acceptance of the need to act that was distinctly lacking during the initial phase of the great financial crisis.

There is even some comfort to be taken from the fact we are in the acute phase of this downturn. Most financial markets participants wish market corrections were a gradual glide down to a predictable bottom and then a linear climb back.

But every downturn brings with it surprises, like the fallout in the UK pensions industry following Elizabeth Truss’s mini-Budget. These surprises often trigger the acute phase that can signal we are at least some way into a downturn, rather than at the start.

While property value declines are painful in the short term - and there is more pain to come - they will bottom, which will present buying opportunities for patient investors. Many of the structural forces at play in the property market will still be there when we emerge. We entered this downturn with a severe undersupply of housing in many markets and we will emerge with one.

Real estate debt will remain scarce, and this will restrict supply, but also present an opportunity for non-bank lenders to originate loans that generate attractive returns.

The capital to provide that financing will also be scarce. But those asset managers who have built up strong relationships with institutional investors through multiple cycles will be able to access sizeable pools capital.

These investors understand from experience that some of the strongest returns are experienced at the beginning of an upcycle and will be aware that the paucity of capital will probably allow them to enjoy better terms than later in the cycle.

The role of non-bank lenders has been growing since they emerged from the GFC. This downturn will mean they will only grow in prominence by ultimately extending credit to more parts of the economy.

The caveat to this optimism is that it relies on the Fed remaining steadfast on inflation. Encouragingly Fed Chair Jerome Powell appears to be making the connection between tightening credit pulling inflation back down via a recession.

But, while the Fed must clearly monitor the stability of the financial sector, over the last decade it has leant too far into one half of its mandate by trying to ease volatility in financial markets at the expense of inflation targeting.

The central bank’s focus has to be bringing down inflation, which means via the principle policy tool at their disposal: interest rates. And that means that investors must accept the burden of higher interest rates to forgo the much greater burden of runaway inflation.

The risk is that the Fed begins to react to turbulence once again in financial markets – as it has done so many times over the last decade – at the expense of tackling inflation.

If it chooses the route of placating markets by returning to lower rates and quantitative easing, then it will only serve to defer what will become a bigger and more painful financial and economic reckoning than the one we are currently experiencing.

The Fed has the opportunity to send a clear message that it really does mean to bring inflation down. It must not blink now.

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Eric Adler

President and Chief Executive Officer of PGIM Real Estate