Archives for April 2022

CBRE’s Levy predicts some cap rate expansion for new long-term net lease deals, “surprising upside” for retail he says is undervalued.

Spencer Levy, CBRE’s Global Chief Client Officer, delivered a bullish outlook of two more years of strong CRE growth in his keynote at GlobeSt’s Net Lease Spring conference, held in New York on Tuesday, dismissing inflation concerns and rising interest rates as “a two-year-blip” during his presentation.

Levy predicted a “surprising upside” to a retail market he says is “undervalued overall by 200 basis points,” surging industrial and multifamily markets “on cruise control” and an “evolving” office market that will see footprints shrink by less than 10 percent.

The CBRE exec underlined the euphoria of a seemingly endless tide of capital flooding asset classes by displaying a slide that instructed the in-person audience to “Don’t Worry, Be Happy.”

Then he delivered a buzz-kill with the illustration for his 2024 forecast: two ancient sailing vessels about to plunge off the precipice of what appeared to be a flat earth where no one thought cap rates would expand or spreads would blow out anytime soon.

After the keynote, Levy’s interpretation of his long-term prognosis sounded like a much softer landing than sailing over the edge of a cliff—with a caveat that labor shortages have the potential to set off an “out of control” inflationary spiral.

Levy said CBRE doesn’t expect cap rates to expand for most industrial and multifamily assets that are recording record rent growth right now, but it does see cap rates expanding for long-term net lease deals that do not have significant annual rent increases, a.k.a. bumps, built into them.

“We do see cap rates for long-term net leases expanding, but how much they’ll rise is the topic of the day,” Levy told GlobeSt.com.

“Long-term, you’re going to see some cap rate expansion and small bumps (in net lease deals), but in the short term you’re going to see a thinning of the market for some disfavored asset classes,” he added.

Levy identified value-add office as an asset that will be pressured by expanding cap rates. “The debt capital market for value-add office that is not stabilized is thin, and the buyer market for that is thin as well,” he said. “That’s the kind of asset that will be most negatively pressured by a rising rate curve because these assets already were under pressure prior to a rate expansion.”

Levy also tempered his “two-year blip” description regarding inflation and interest rates, noting that CBRE recently upped its projection of 2022 interest rate hikes by the Fed from 4 to 7.  He also said the severity of the inflationary cycle will be determined by whether the labor shortage can be alleviated.

“Labor is the whole story as far as I’m concerned,” he told us. “If we don’t figure out a way to solve the labor shortage, that’s where inflationary pressure is going to spiral out of control.”

With a slide he titled “The Scariest Thing You’ll See Today,” Levy told the audience at the Westin Times Square that e-commerce’s penetration of retail, which rose to a 26 percent share in 2020, actually declined last year and appears to be plateauing in recent months at about 22 percent.

“I’m not saying e-commerce has peaked, but there’s a risk factor that e-commerce will peak a lot sooner than people think,” he told us. “Last year, e-commerce penetration dropped. Is it a temporary drop or a permanent drop? Nobody knows the answer to that question.”

Regarding workers returning to offices, Levy said workers and employers are in the midst of “a classic labor-management dispute” over how many days per week employees are needed in the office. He projected that this will shake out to 3-4 days per week, depending on job functions.

“What we’re seeing in offices is not a real estate story, it’s a labor story,” he said. “What we have right now is such a tight labor market that labor is asserting its rights.”

Source: “Smooth Sailing for Net Lease Cap Rates Until 2024. Then, Watch Out“

Many in the investment community worry that increasing interest rates in the coming year might have an adverse effect on their apartment property values.

With both inflation and interest rates rising, following the first Federal Reserve rate hike in three years, many multifamily investors are fearful about the impact these duel forces will have on apartment cap rates, which have trended downward over the last twenty years.

In Q4 2021 apartment cap rates reached a low of 4.7%, down 30 basis points since the prior year, according to apartment transaction data tracked by Real Capital Analytics that the National Multifamily Housing Council cited in a recent post.

Just ‘Aggressive’ Enough

Interest rate hikes that are too aggressive could put a damper on economic growth prospects, which would have an adverse impact on property values and upward effect on cap rates, NMHC said. Cap rates could also potentially face upward pressure in markets with diminished rent growth projections, as seen in the San Francisco and New York City markets over the past five years.

Still, apartment cap rates are fundamentally a real rate of return that should only be affected by changes to the real rate of interest, the association said, noting that “apartments, given the short-term nature of their leases, are uniquely positioned to simply re-price their rents during inflationary periods in order to offset higher nominal interest rates.” The NMHC points out that even though the 10-year Treasury has already inched upward, the apartment market continues to benefit from historically high occupancy rates and rent growth, causing cap rates to further decrease.

Furthermore, with apartment transaction volume at record levels, investors may simply be willing to accept a lower premium for holding apartment properties.

NMHC reported further on reasons why nominal interest rates may have less of an impact on cap rates than might be expected.

Weak Correlation Between Nominal Interest Rates, Cap Rates

Interest rates influence borrowing costs for investors. For decades, declining long-term interest rates have bolstered the value of apartment properties, causing cap rates to decrease.

Still, the correlation between long-term interest rates (represented by yields on the 10-year Treasury) and apartment cap rates is not particularly strong, NMHC said. For example, the market yield on 10-year Treasuries increased from 3.6 percent in 2Q 2003 to 5.1 percent in 2Q 2006, during which time apartment cap rates decreased from 7.6 percent to 6.4 percent.

Ten-year yields also rose from 1.6 percent to 3 percent between 3Q 2016 and 4Q 2018, while cap rates edged down slightly from 5.6 percent to 5.5 percent. And, most recently, 10-year rates rose from 0.7 percent in 3Q 2020 to 1.5 percent in 4Q 2021, all while apartment cap rates decreased to record lows.

Cap Rates as a Real Rate of Return

The context around why nominal interest rates are rising is also important. Since the most recent rise in 10-year Treasury rates was simply in response to higher inflation, there hasn’t been much of a change to the real, long-term rate of interest.

Apartments, given the short duration of typical leases, are uniquely positioned to re-price their rents to keep up with inflation. While the consumer price index rose 7.1 percent year over year in 2021 and 7.9 percent as of February 2022, rents for professionally managed apartments tracked by RealPage rose by an even greater 10.5 percent year-over-year for new leases and 8.1 percent for renewals as of November 2021.

If higher borrowing costs are offset by higher growth rates in rent and NOI, cap rates should remain unchanged. In other words, cap rates can be thought of more as a real rate of return, which are only affected by changes to the real interest rate.

Impact of Rent Growth on Prices

Still, apartment rent growth has lagged inflation in every market or unit type over the past two years. For instance, inflation (measured by changes in CPI) averaged 8.6 percent between 2020 and 2022, while rents tracked by RealPage rose an average of just 2.6 percent in Los Angeles, 2.2 percent in Boston, 2.1 percent in Seattle and 1.8 percent in Washington, D.C.

Rents declined an average of 0.2 percent per year in New York and 6.3 percent per year in San Francisco during this two-year period. And rent growth over the past two years was even lower among one-bedroom and studio apartments.

Source: “What Rising Interest Rates Mean for Apartment Cap Rates“

Many believe a yield curve inversion means a recession is coming.

Last week’s very brief yield curve inversion has increased investor concern, but one expert is calling for cooler heads to prevail.

“I think there are some misconceptions about what yield curve inversions are and what they mean,” says Marcus & Millichap’s John Chang in a new video. A yield curve inversion happens when short-term Treasury rates pay a higher interest rate than long-term Treasuries, and the most commonly tracked version of this is the 2/10 yield spread. That refers to the difference between the two-year Treasury and the ten-year Treasury.

“Many believe a yield curve inversion means a recession is coming, and you may see that in the news a lot in the coming weeks,” Chang says. “But I need to point out that an inverted yield curve is just one indicator and it’s not bulletproof.”

By way of example, Chang notes that the 2/10 yield spread went negative in 1998 and was not followed by a recession – what he refers to as a “false positive.” Other economists, he says, prefer to instead examine the spread between the three-month Treasury and the 10-year Treasury, which allows for a longer historical dataset and theoretically more accurate reading since more pressure is required to move the spread. That spread also shows two false positive yield curve inversions, one in 1967 and another in 1998.

Currently, Chang says, the 10-year Treasury rate is 180 bps higher than the three-month rate.

“That metric hasn’t inverted and it looks like there’s plenty of maneuvering room there,” he says. “Of course this doesn’t explicitly mean there’s no recession coming—but simply that this particular indicator isn’t blinking red.”

Going forward, investors should expect higher than normal interest rate volatility and higher than normal risk of the yield curve inverting, thanks largely to the Fed’s continued efforts to tamp down inflation through a series of seven planned rate hikes this year. That will likely increase pressure on short term rates, increasing interest rate volatility and potentially causing inversions.

So what’s this mean for investors?

“First, don’t get lost in the news,” Chang advises. “Yes, a recession is probably out there somewhere, but don’t get too focused on it. Second, the next recession won’t be anything like the last two, the pandemic recession or the financial crisis. The drivers are completely different.”

Chang predicts the next recession will likely be “comparatively mild” and akin to those of the early 1980s and 1990s.  Comparatively low unemployment and high household savings will likely mitigate inflationary pressure in part.

But “the key economic drivers investors need to factor into their strategies are inflation risk and interest rate risk,” he says. “That means focusing on real estate that can increase revenues to keep up with inflation and using fixed rate debt. Those basic guidelines should help mitigate risk.”

Source: “What The Recent Yield Curve Inversion Means For Investors“