The residential real estate market looks to be booming with reports of the strongest seller’s market in years. Following the housing crisis, national home values have appreciated nearly 30% from their lows in 2012, exceeding pre-crisis highs in many markets. While things look rosy in the residential market, the commercial market is signaling some warning signs. Although these two segments don’t perfectly mirror each other, there is significant correlation. In the Los Angeles market sales price and volume just dropped off a cliff. Even though this may be idiosyncratic, the commercial real estate market is currently undergoing a major upheaval in retail. The internet revolution has been with us for years now, but its disruption has taken years to play out. Consumer habits are shifting in favor of online apparel purchasing, which is now expected to pass electronics as the largest market segment in online shopping. Consequently margins have been squeezed and with the trend showing no signs of reversing, major retailers are closing numerous stores. Though retail’s woes don’t perfectly translate to industrial or office, the broader industry has seen compressing capitalization rates for years. These were largely driven by extremely low interest rates, which doesn’t bode well in the upcoming monetary environment.

The Federal Reserve has finally started to ratchet up the rate of its interest rate hikes, with three expected this year. Rising interest rates will put upward pressure on cap rates and as cap rates begin to rise, expect property values to fall. There is already some evidence of this in the southern California suburban office market. Another repercussion, but less discussed, is the Fed’s effect on the residential market due to its large holdings of mortgage backed securities, MBS. In an effort to combat the specter of deflation, the Fed purchased trillions in US Treasuries and MBS and currently holds roughly $2.5 trillion in Treasuries and $1.75 trillion in MBS. This is a significant share of the market which was estimated at $7.5 trillion in 2013. It is still uncertain how the Fed plans to deal with its holdings, but there are two general options discussed. First, would be to hold the debt to maturity, which would slowly shrink the balance sheet over years. The other, which is gaining some traction, is to slowly sell off their holdings. If the latter is chosen, there will be additional upward pressure on borrowing rates for real estate purchases. The Feds winding down of its monetary experiments poses significant headwinds for the real estate market. The market has been on a strong run for the past five years, but there is little room left to run and a correction is due.