At JLAM, we do not claim to know where interest rates will be in the future. We can’t say with 100% certainty whether the Fed will cut rates later this month and if they do, whether it will be by 25 bps or 50 bps. We do, however, think we can deliver attractive risk-adjusted returns to our investors regardless of what the Fed decides at its next FOMC meeting. That said, the consensus among market participants is that the Fed will cut rates later this month according to the Atlanta Fed’s Market Probability Tracker. So, what could a rate cut mean for JLAM and its investors?
Land Development
Our land development projects mostly entail acquiring fully zoned and entitled land, completing horizontal development (such as grading, installing water & sewer infrastructure, landscaping, constructing amenities), and selling finished lots to builders. We typically fund these deals using 100% equity (i.e., we do not take on debt). We do not believe the use of debt is appropriate for these investments as it introduces unnecessary risk, and the unlevered returns are sufficiently attractive. Since we do not use debt to fund these investments, changes in interest rates do not have a direct impact on the finances of our projects (but the availability and cost of debt does play into the competitive landscape). However, we expect that a Fed rate cut will benefit our land development activities in other ways.
Our land development is a precursor to homebuilding activity. We sell finished lots to national and regional firms like NVR, Schell Brothers, K. Hovnanian, and other well-known homebuilders. Oftentimes, these builders will borrow a portion of their building costs from a bank. As such, a reduction in market interest rates will lower the builders’ borrowing costs, potentially allowing them to build more homes and/or to charge a lower price for their homes (lower prices should increase the pace of sales). Furthermore, lower rates are likely to entice more people to buy homes. The combination of lower borrower costs for builders and homebuyers alike could translate to increased homebuilding activity, increasing the demand for JLAM’s development services from homebuilders. (There is a counter to this—lower mortgage costs unlock re-sale inventory, as people with low rates are now open to selling and buying a new home, so new home sales face increased competition from the re-sale market. Given the significant amount of people with sub-4% rates, I don’t think the near-term cuts will have this effect, but sustained rate cuts, if they translate to lower 30-year rates, could have this effect.)
Lending
Our private credit strategy is focused on lending capital to high-quality sponsors in need of preferred equity, mezzanine debt, and/or rescue capital. Intuitively, a Fed rate cut sounds like it would detract from this strategy’s returns, as we would not be able to charge as high of interest rates to our borrowers. While this may be true eventually, we believe there will be a lag in the need to cut our lending rates due to the significant imbalance of supply and demand for capital from stressed and distressed borrowers. We believe the need for capital greatly outweighs the availability of capital given the state of bank balance sheets and tightening bank lending standards. As such, we do not expect to lower our return targets if the Fed takes action.
Acquisitions & Dispositions
The impacts of an interest rate cut are likely to vary across property types and geographies, so we’re wary of generalizing. Capitalization rates (cap rates) are broadly expected to decline with market interest rates. A cap rate represents a property’s yield, which can be evaluated in terms of the spread it offers above a risk-free rate (e.g., the yield on the 10-Year U.S. Treasury). If the spread remains consistent over time, then cap rates would naturally decline when the risk-free rate declines, which it’s expected to do when the Fed cuts rates. However, there are other factors at play, such as the supply and demand for different property types in different locations.
Individual properties need to be evaluated on their own merits, including positioning in the marketplace, physical differentiation, and more. For example, commercial office has been on a decline (on average) due to the uncertainty around shifts to remote and hybrid work. The lack of investor demand has generally caused office cap rates to increase with a corresponding decrease in office property values (as Net Operating Income / Cap Rate = Property Value). We expect this broad trend will continue despite an expected rate cut. However, there may be attractive opportunities to acquire newer vintage office properties in growing suburban locations such as Charlotte, NC; Charleston, SC; or other booming metropolitan areas, for example. In those cases, cap rates will likely be relatively immune to rate cuts given the attractiveness of the assets in the context of their locations, demographic trends, etc. By contrast, multifamily properties have been the darling of investors for several years, particularly during the COVID-19 pandemic when landlords were able to grow rents drastically. What followed was a credit-fueled boom in new construction of multifamily properties creating oversupply in notable Sunbelt markets like Austin, TX, where rents are now on a year-over-year decline. We expect the oversupply in markets like Austin may lead to a period of declining property values and rising cap rates despite the Fed’s actions, which could present interesting entry points for investment.
We’re careful at JLAM not to jump to conclusions about an asset based on the headlines. Our investment team looks at each buy or sell decision from multiple perspectives and conducts holistic analyses before deciding to acquire or dispose of a property. Interest rates are merely one factor among many.