The Federal Reserve & Interest Rates

A central bank is a special institution — created by a country's government, but typically run with considerable independence from day-to-day politics — that manages a nation's money supply and oversees its banking system. In the United States, that institution is the Federal Reserve System, created by Congress in 1913 and commonly called 'the Fed.' It has three main parts: a Board of Governors based in Washington, D.C.; twelve regional Federal Reserve Banks located in major cities around the country; and the Federal Open Market Committee (FOMC), the group that actually votes on interest rate policy, at eight scheduled meetings a year (roughly every six weeks).

Congress has given the Fed a dual mandate — two co-equal jobs to pursue at once: (1) stable prices, which in practice the Fed targets at roughly 2% inflation per year (using the exact inflation math from the previous topic), and (2) maximum sustainable employment, meaning as many people working as the economy can support without overheating. These two goals often pull in opposite directions: raising interest rates to fight inflation tends to also slow hiring, while cutting rates to boost jobs tends to also push prices up. Most Fed decisions, meeting after meeting, are a balancing act between these two goals, reacting directly to the GDP, inflation, and unemployment data covered in the previous topic. Almost nobody outside finance thinks about the Fed day to day, but in commercial real estate, nearly every important number you will calculate — a loan's interest rate, a cap rate, a discount rate — traces back, directly or indirectly, to decisions made by this one committee.

The Fed's main tool is setting a target range for the federal funds rate — the interest rate banks charge each other to borrow reserves overnight. On its own, this is a very short-term, bank-to-bank rate with nothing directly to do with a commercial real estate loan. But a whole chain of other interest rates is built on top of it, so when the Fed moves its target, those other rates move too, almost immediately.

The clearest example is the U.S. prime rate — the base rate banks quote their most creditworthy customers, and the rate many business and commercial loans are priced off of (as a spread over prime, such as 'Prime + 1.00%'). For decades, the prime rate has moved in near-lockstep with the Fed's target, running almost exactly 3.00 percentage points above the midpoint of the Fed's target range.

Worked Example 1 — Prime rate follows the Fed, point for point. Suppose the FOMC's current target range for the federal funds rate is 4.75% to 5.25%. The midpoint is (4.75% + 5.25%) / 2 = 5.00%, so prime rate ≈ 5.00% + 3.00% = 8.00%. Now suppose at its next meeting the FOMC cuts its target range by 0.75 percentage points (75 basis points — a 'basis point' is 1/100th of one percent, so 75 basis points = 0.75%), moving the range down to 4.00%–4.50%, a new midpoint of 4.25%. Prime rate then falls to approximately 4.25% + 3.00% = 7.25% — down by exactly the same 0.75 percentage points, moving dollar-for-dollar with the Fed's decision because it is mechanically tied to it.

A similar relationship holds for SOFR (the Secured Overnight Financing Rate), the reference rate most floating-rate CRE loans are priced off of today. SOFR tracks overnight lending in the Treasury repo market and moves closely with the Fed's target rate as well, which is why floating-rate CRE loans are commonly quoted as 'SOFR + a spread,' such as 'SOFR + 300 basis points.'

This is where the Fed stops being an abstract news headline and starts affecting real dollars. Many commercial real estate loans — especially short-term bridge loans and construction loans — carry a floating interest rate, meaning the rate resets periodically based on a reference rate like SOFR, plus a fixed spread.

Worked Example 2 — A Fed rate cut flows straight through to a borrower's monthly payment. A borrower has a $5,000,000 interest-only bridge loan priced at SOFR + 3.00%. SOFR currently sits at 5.00%, so the loan's all-in interest rate is 5.00% + 3.00% = 8.00% per year. On an interest-only loan, the monthly interest payment is simply the balance times the annual rate, divided by 12: $5,000,000 x 0.08 / 12 = $400,000 / 12 = $33,333.33 per month.

Now the Fed cuts its target rate, and SOFR falls one-for-one by 1.00 percentage point (100 basis points) to 4.00%. The loan's all-in rate resets to 4.00% + 3.00% = 7.00%. The new monthly interest payment: $5,000,000 x 0.07 / 12 = $350,000 / 12 = $29,166.67. The borrower's monthly payment drops by $33,333.33 − $29,166.67 = $4,166.66, or $50,000.00 over a full year ($400,000 − $350,000). A single Fed decision — with no change to the property, the borrower, or the loan terms other than the floating rate resetting — saved this borrower $50,000 a year.

Interest rates don't just affect loan payments — they affect what investors are willing to pay for a property in the first place, through the cap rate (short for capitalization rate, covered in depth in a later block). For now, the intuition: a cap rate is the annual return an investor requires, expressed as a percentage of price paid, to buy a property producing a certain amount of net operating income (NOI). Under the simplest valuation formula, Value = NOI / Cap Rate.

Investors generally build a cap rate up from a 'risk-free' rate (heavily influenced by the Fed and by U.S. Treasury bond yields) plus a risk premium demanded for real estate's extra risk and illiquidity compared to a government bond. When the Fed raises rates and the risk-free rate rises, investors typically demand a higher cap rate too, all else equal — and because cap rate sits in the denominator of the valuation formula, a higher cap rate on the same income stream produces a lower value.

Worked Example 3 — The same building, two different cap rates. A property generates $800,000 of NOI per year. When rates are low and the market cap rate for this property type is 6.00%, Value = $800,000 / 0.06 = $13,333,333.33. Now the Fed raises rates sharply and the market cap rate for this property type rises to 7.00%, with NOI unchanged. New Value = $800,000 / 0.07 = $11,428,571.43. That's a drop in value of $13,333,333.33 − $11,428,571.43 = $1,904,761.90, or about 14.3% of the original value ($1,904,761.90 / $13,333,333.33 = 0.1429), purely from a one-percentage-point rise in the cap rate, with the building's income completely unchanged. This is exactly why CRE professionals track Fed announcements as closely as they track their own rent roll.