The markets have become “choppier and murkier” as inflation and rates rise, according to a new analysis from a trio of Cushman & Wakefield economists.
“History suggests that CRE markets have been largely resilient to higher inflation and rising rate environments as long as the economy keeps growing. That said, we are in unprecedented times,” the firm’s David Bitner, Kevin Thorpe, and Rebecca Rockey write in a new report modeling a variety of economic scenarios. They note that CPI inflation is currently at 8.2% YOY, a four-decade high, and say there are “increasing signs” that recent interest rate hikes, together with market uncertainty, is putting upward pressure on cap rates. In addition, REIT implied cap rates have already ticked up.
But “at the same time, many economic fundamentals remain strong, and investors have accumulated enormous amounts of capital to deploy into CRE—that genie isn’t going back in the lamp,” the report notes. “Strong headwinds continue to collide with strong tailwinds, creating many different scenarios, some more likely than others.”
The Cushman economists say that changes in either the federal funds rate or the 10-year Treasury “have had no consistent association with changes in cap rates” and “are, in fact, uncorrelated at face value… why Treasury rates move matters for what happens to cap rates, not the movement alone.”
“If the economy is growing, cap rates have tended to decrease with the rate of cap rate compression proportional to how far cap rate spreads are above or below their long-term average,” they write. “In other words, in general, as long as the economy is growing, then yields have tended to be stable or more often falling (implying that property values can and often do rise in a climbing interest rate environment)”
But that historical pattern may not apply today, they say. Two reasons: earlier periods benefit from a long-term downward trend in interest rates “whereas that trend now appears to have bottomed or even reversed,” and while rates often rise as the growth environment improves and risk aversion declines, the opposite appears true now.
Cushman experts say the cost of low leverage, fixed-rate RE debt has tracked Baa bonds historically, and they are again today. They cite Trepp’s balance sheet lender survey, which indicates that low leveraged fixed financing costs have risen to 4.7% today from a level of 3.2% at the beginning of the year. Cap rate spreads have narrowed in response or even turned negative, especially for asset classes like multifamily and industrial.
Their advice for investors? “Aggressively challenge” assumptions when making buy and sell decisions.
“Usually, investors have done well to focus cash flow growth in periods of volatility, but even this path has become treacherous with the fastest growing sectors also the most exposed to rate risk,” they write. “Which force wins out will vary from asset to asset as usual but will also be contingent on the path of the macro environment over the next several years.”