by Rachel L. Richardson
According to the CEO of the largest publicly traded office landlord in the U.S., BXP, “Commercial real estate markets are currently in a recession.”
No, the National Bureau of Economic Research (NBER) has not yet declared a recession for the U.S. as a whole. Speculations about such an announcement have been flying ever since we experienced two successive quarters of negative GDP in 2022, but no official declaration of recession has been made since key economic metrics continue to post mixed results. From a national perspective, there is still a high chance of a recession in 2023, but the forecasts are better than expected.
In his outlook earlier this month, John Chang, Senior Vice President of Research Services at Marcus and Millichap, highlighted macroeconomic positives, such as declining inflation and normalizing supply chains. These are, however, offset by the number of job openings, which are still “twice the historical average.”
“Net-net, it looks like inflation will continue to recede,” Chang notes. “The question will be whether the Fed also sees that trend and whether they think it will come down fast enough.”
- CRE is considered in a recession, though the NBER has yet to declare the nation is.
- Year-over-year inflation is declining.
- Many indicators suggest continued contraction that would lead to lower inflation.
- The Fed continues its quantitative tightening, albeit with less aggressive moves for the federal funds rate.
- Changes to the federal funds rate and 10-Year Treasury yields are not directly correlated to changes in cap rates.
- Cap rates are most closely correlated with the cap rates from the prior quarter.
While the national outlook is undecided, commercial real estate (CRE) is a bit clearer. Like single family housing before it, CRE has slowed tremendously under the aggressive rate hikes of 2022. In response to this CRE recession, BXP is “shoring up its liquidity and pushing out its debt maturities.” Like other investors in CRE, BXP is prioritizing the management of their leverage and liquidity as they strive for a favorable position amid the changes in the Federal Reserve’s (Fed’s) monetary policy and potential national recession.
Federal Funds Rates at a Glance
Early in 2022, the effective federal funds rate (EFFR) was hovering near zero. As inflation gained traction, the Fed began increasing the rate—by an initial 25 bps in March 2022, to a total of 425 bps by year end. In their announcement of February 1, 2023, the Fed raised the rate by 25 bps, bringing it to 4.50%–4.75%.
This move was widely anticipated, as market participants were hopeful the declining core PCE inflation would encourage the Fed to instate a softer rate increase—with a final, small increase in March before entering what they hoped would be a holding period for the remainder of 2023. The Fed recommitted to ongoing increases, however, indicating a likely hike in May as well—and possibly beyond. Market participants will keep a keen eye on the results of the Fed’s March and May meetings along with the corresponding commentary. Should both meetings net 25 bps increases, the rate would reach 5.00%–5.25% in May.
Cap Rate Expectations
Our prior post on cap rates discussed the nature of cap rates, factors that can influence them, and how investors expect they will fluctuate given the rise in interest rates due to the Fed’s monetary policy. Given historical trends, investors anticipate the rise in interest rates will correspond to a decrease in asset sales prices, and by extension an increase in cap rates.
The Green Street Commercial Property Price Index reflects this, showing that the index declined 13% in 2022. The commentary on the data release noted healthy rent growth outweighed by lower sales prices due to an increased cost of borrowing. Cap rates, they add, are still low compared to yields on corporate bonds, and are likely to continue increasing.
A Note on 10-Year Treasuries
The 10Y Treasury Note (T-note) is used as a proxy for mortgage rates and is believed to be a bellwether for investor sentiment. For this reason, many investors believe that when the 10Y Treasury yield rises, cap rates will follow suit.
“Contrary to conventional wisdom,” a Berkadia whitepaper notes, “bond yields and cap rates do not have a one-to-one relationship.” Instead, the correlation between the two varies over time. Their relationships can be further distorted by deflation/inflation or disinflation, as at times bond yields and cap rates may move together, separately, or be “largely uncorrelated.”
A second Berkadia whitepaper takes a closer look at the interplay between actual inflation, inflation expectation, yields on the 10Y Treasury, and cap rate yields. They find that both changes in actual and expected inflation are related to 10Y Treasury yields, but that expected inflation proves to be a stronger corollary.
Further, they find “nominal cap rates behave a lot like real interest rates.” Plotting the average spreads between cap rates and the 10Y Treasury alongside those of real Baa corporate bond yields (DBAA) and the 10Y Treasury, they find “the average cap rate spread is equivalent to the average real DBAA spread plus a roughly constant delta.”
Though cap rates and T-note yields do not have a one-to-one relationship, they note: “Post-GFC, a 100-bps movement in nominal (T-note) yields and inflation-adjusted (T-note) yields is associated with a movement in the average cap rate of 51 bps and 44 bps, respectively.”
Significantly, though, they add that cap rates can remain “sticky” as cap rates from the immediately prior quarter will be most highly correlated with cap rates from the current quarter.
Each whitepaper was focused primarily on multifamily data.
Taking a broader range of CRE asset types, a whitepaper presented by Crow Holdings and SMU Folsom Institute for Real Estate attempted to project (in Q2 2022) how cap rates would respond to the rise in the federal funds rate over the course of the year (given an expected rate hike trajectory that did not end up matching the actual rate hikes made in 2022). It takes a historical view of the topic, focusing first on the real estate cap rate spread in relation to the 10Y Treasury yield. Second, it analyzes this spread in light of a varying inflation rate, and finally it notes the relationship between the yield on the 10Y note and short-term interest rates. Together, it frames a conversation around cap rates, based in the historical trend. Though its predictions about the Fed’s moves have not proven correct, the analysis is worth a read (if you’re feeling nerdy, that is).
So where does this leave CRE? Market participants will be keeping a close eye on the federal funds rate in March and May, and any accompanying commentary the Fed will provide at those points. The question will remain, too, how long will the elevated interest rates remain after the Fed enters a holding pattern? (The Crow Holdings whitepaper notes that for the most part the Fed has reduced rates by 200 bps within 12 months after the peak in their rate hike cycle.)
Now—as always—the valuation professionals at Valbridge remain committed to keeping abreast of both macroeconomic trends and the impacts in their local markets, analyzing metrics for each subject property in light of recent comparable data.