U.S. Macro Outlook: Mild Recession ≠ Pleasant

CUSHMAN & WAKEFIELD RESEARCH U.S. Macro Outlook

CAPITAL MARKETS

In fourth quarter of 2022, the all-property cap rate was 163 bps below the Baa rate—an unsustainable position that we expect will correct in 2023 and 2024 as we call for a 260-bps expansion (in the level of the all-property cap rate) over this time. Of course, this is just an average. There is a marked difference in the resiliency of the highest quality assets, particularly those with long-term leases in place, versus the rest of the market. Moreover, there is often a flight to quality dynamic that takes place during economic downturns which limits the downside for prime assets, while riskier assets often experience a more significant price correction. All else equal, one might expect cap rates to follow Baa yields higher at a one-to-one ratio, but that is rarely the case as income dynamics are also a factor. Broadly speaking, real estate fundamentals

have been improving post-pandemic, resulting in income growth and occupancy gains, especially among high-quality assets. Additionally, CRE assets are typically held over a long-term period of more than five years, and interest rates are expected to be lower five years from now, which supports our baseline narrative that cap rates will not increase as much as yields for other financial assets like corporate bonds. The significant amount of dry powder targeting CRE investment is still trending near historical levels, at $242 billion in early 2023, which will also support continued investor demand, insulating cap rates from some upward expansion as compared to past cycles. Said differently, we make a case that we are likely to see tighter cap rate spreads relative to benchmark rates than in prior historical periods and perhaps more on par with those observed in the 2015-2019 period.

Fuller Picture of Investor Returns

It is critical to keep in mind that real estate returns are generated on a cumulative basis over the hold period, and total returns for a given vintage year investment can still be positive given the steady income and significant appreciation returns that have accrued over the last several years. In an illustrative example (see below), we show the cumulative forward returns of an investment made in fourth quarter of 2017. At five years ending in the fourth quarter of 2022, when cap rates were lower than Baa bond rates, an investor would have made a cumulative 73% return, outpacing alternative cross-asset options. If said investor were to exit at the bottom of the market—defined as the trough for values in our forecast—their return would be 33%, still outpacing inflation and several other asset types. Over a 10-year horizon, this investor would benefit from post-downturn tailwinds, subsequently realizing total returns that are attractive across the cross-asset class spectrum. RELATIVE CUMULATIVE FORWARD TOTAL RETURNS Q4 17 INVESTMENT RETURNS BY HORIZON

If Invested in Q4 2017…

100%

80%

60%

40%

20%

0%

5-year horizon

7-year horizon

10-year horizon

CRE - All Types CPI

Baa Bond S&P500 DJ Gold Oil (WTI)

Source: NCREIF, Cushman & Wakefield Research. All types cap rate calculated for four main property types using weights based on capital investment share from 2018-2022.

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