U.S. Macro Outlook: Mild Recession ≠ Pleasant

CUSHMAN & WAKEFIELD RESEARCH U.S. Macro Outlook

CAPITAL MARKETS

The Ripple Effect of Rising Interest Rates No part of the CRE world has been as immediately impacted by the shift in interest rates as the capital markets. The FOMC increased the target federal funds rate by a cumulative 425 bps in 2022 followed by a 25-bps increase in February 2023, in what has been the fastest rate-hiking cycle since the early 1980s. Despite recent signs of optimism in bond futures markets, we believe that elevated inflation in services (excluding housing) and an extremely imbalanced labor market will support Fed policy in which interest rates remain higher for longer than is expected by the consensus, resulting in ongoing volatility in the financial markets. 7 With the FOMC likely to hike rates at least two more times (our baseline view), there is potential for additional increases (but likely not many). Although the 10-year Treasury rate remains below the short end of the yield curve for now, it is slated to un-invert as growth expectations of a new business cycle reemerge. Therefore, our call for higher 10-year Treasuries and Baa corporate bond rates is in line with our view that after a brief recession, the economy is poised for a new stage of growth. The era of significant cap rate compression over the last few years has ended and the market is transitioning into an “income-focused” phase. Without capital value appreciation driving total returns—particularly this year and next—the fundamentals really come to the fore. We are entering a period of negative capital appreciation returns across property sectors as cap rates increase and as values decline and weigh on returns. However, on a cumulative, rolling vintage-year basis, total returns are still positioned relatively well, given that we are coming off several years of above average (in some cases double-digit) total returns. So, while the isolated, single-year total returns will come under pressure as the shift to higher interest rates plays out, the overall picture for returns is not altogether downbeat. Fortunately for CRE, income returns have proven to be durable and reliable, underscoring a key facet of its attractiveness as an asset class. Assuming our base case scenario plays out, and assuming the Fed begins to cut rates early in 2024, we expect capital markets conditions to bounce back relatively quickly, which will bolster capital returns and provide many buyers with opportunities ahead of that inflection. Although private CRE property values typically lag movements in other asset prices by several quarters, pricing trends between CRE and other investment 7 While financial markets are good at predicting one- and three-month ahead changes in interest rates, they are not good at predicting inflation or interest rates otherwise. In fact, financial markets perform worse than surveys of professional economists and business leaders. Over-weighting market expectations for year-end 2023 should be done with caution.

classes have historically been correlated over previous economic cycles. The degree of co-movement varies depending on factors such as the economic outlook, investor perception of cross-asset class risk and liquidity considerations. Ultimately, investors have myriad options where they can place capital to yield a target return, ranging from the ultra-low-risk U.S. Treasury market to corporate stocks and bonds. CRE falls toward the riskier end of the spectrum, not only due to an illiquidity premium, but also due to inherent uncertainties involved with owning property—occupancy and rent volatility, operating expenses, taxes and regulations, insurance, climate risk, etc.—all of which carry far more risk than a government bond, which is guaranteed at a set yield under almost any circumstance.

CAP RATES DESTINED TO INCREASE ALL-PROPERTY CAP RATE SPREAD TO BAA BONDS (BPS)

400

200

0

-200

-400

-600

-800

-1,000

1991

1982

1983

1985

1988

1997

1992

1995

1986

1989

1998

2012

2021

2013

2015

2018

2016

2019

1994

2001

2010

2022

2007

2003

2006

2009

2004

2000

Source: Moody’s/Moody’s Analytics, NCREIF

As a result, relative returns in the bond markets are sure to influence real estate yields, although to what extent is a bigger question. If investors can yield 4% on a 10-year Treasury note, for example, a property expected to yield a similar—or even lower— amount becomes even less appealing, particularly given its risk factors. The upside potential to drive income or capital appreciation growth would have to be enough to justify a lower going-in yield. On average from 2000-2022, all-property cap rates 8 have traded at an average of 98 bps spread to Baa rated corporate bond yields, though this spread has ranged from near zero to almost 380 bps over that period. Since the start of 2022, the Baa yield has tracked Treasury yields higher, rising nearly 300 bps to a peak of 6.3% in October 2022—rates have since drifted down to the 5.5% range, yet are still higher than any time in the last decade.

8 We calculate the all-property cap rate of the four main asset types (multifamily industrial, office and retail) using weights based on capital investment share from 2018-2022.

11