CUSHMAN & WAKEFIELD RESEARCH
Uncertainty and volatility surrounding Fed policy and the path of interest rates remains a central theme, as markets have witnessed the 10-year Treasury fluctuate from 3.5% at the start of the year to as high as 5.0% in October—with big swings along the way. The adjustment process to higher costs of capital takes time to cascade throughout the debt and capital market space, yet it is the pronounced uncertainty, in particular, that has made it difficult for lenders and investors to price debt and underwrite deals with conviction. Meanwhile, the regional banking failures of earlier this year also caused one of CRE’s primary lending sources, banks, to pull back further on lending amid liquidity constraints and heightened regulatory oversight. Collectively, these challenges have contributed to slower CRE mortgage origination in 2023.
📣 Abby Corbett, Global Head of Investor Insights
Challenges aside, mortgage debt continues to flow, albeit with a distinct tone of caution and selectivity, at a reduced pace compared to last year. CRE loan balances—including construction, nonresidential CRE, and multifamily loans—held by domestic commercial banks have increased 6.3% from a year ago, which is comparable to the rate of growth in 2019. Risk premia for CRE loans relative to comparable risk-free Treasurys surged as high as 312 basis point (bps) this spring amid banking concerns, but have since settled into the 285 bps range in recent months, or about 50 bps higher than 2019 spreads.
Transaction volumes have fallen sharply since the record-setting second quarter of 2022, and year-to-date CRE sales this year are off 56% from a year ago. Yet, quarterly deal volume has trended remarkably consistently throughout the year, in the $90 to $95 billion range through the third quarter.
Compared to average quarterly performance from 2017-2019, transactions are down only 33%, so the market is not as displaced as would be suggested by the year-over-year (YOY) comparison.
Higher borrowing costs and less debt market liquidity have necessitated an adjustment in CRE pricing. According to the MSCI CPPI, all-property prices in October were down 10.1% from the 2022 peak and 8.0% from a year earlier. However, pricing for publicly traded CRE REITs is down nearly 30%, suggesting that further price adjustment is needed in the private market. That premise becomes even more evident when comparing cap rates to alternative assets. For example, the Moody’s BAA bond yield in the third quarter was trading at a 150-bps premium to CRE cap rates; this spread is usually inversed where CRE carries a premium to corporate bonds. Pricing will naturally continue to correct as needs-based sellers not willing or able to refinance at current mortgage rates find new equilibria of market-clearing prices. Although a higher number of distressed sales is expected in 2024, the broader price adjustment is likely to occur gradually over several quarters.
The period of ultra-low interest rates that boosted activity over the past few years is likely over, but that is not a precondition for healthy capital flows. After all, 10-year Treasury yields in the 4-5% range is not high by historical standards. Markets just need clarity on where rates are generally headed to make informed underwriting decisions. Fortunately, this condition is within reach after the Fed’s recent pause. Thanks to continued improvement in inflation data and some help from the higher long-term Treasury rates, Fed officials are now strongly signaling that further rate increases are unlikely. Bond traders have taken this a step further, pricing in lower short-term rates by May or June of 2024. If economic growth tracks our baseline forecast for a moderate recession to take hold, a Fed pivot is very likely. But it’s important not to conflate a Fed pivot with a return to near-zero rates. Yes, the Fed will take measures to stimulate the economy but it’s unlikely to make drastic rate cuts barring a full-blown financial crisis. For now, this seems to be well understood by market participants. Terminal cap rate assumptions have moved higher across major CRE asset types, signaling that investors are adjusting underwriting for higher debt costs over the long term.
The pricing adjustment is expected to accelerate in 2024 as needs-based sellers will be incentivized to market properties at prices consistent with higher interest rates. In our baseline forecast, cap rates are forecast to expand significantly as a result. This necessary cap-rate adjustment will help to restore some semblance of comparative spreads, whether that be to risk-free Treasuries or to risk-adjacent corporate bond yields. Weighted-average cap rates across the four main property types move from 4.5% in 2023 to 7.3% in 2024 although the range spans from a 190-bps expansion for retail to 310-bps for office assets. While these moves seem drastic over a short period, cap rate spreads relative to Treasuries and corporate bonds in our baseline remain below long-term averages, with the exception of office spreads. We also emphasize that all real estate is intensely local and many assets and geographies will outperform these aggregate national estimates. Moreover, many owners with cash-flow positive properties will hold through this period without having to actualize any meaningful price correction. But in the aggregate, capital value depreciation is unavoidable across property types given the favorable relative returns for alternative assets, so investors are likely to focus more acutely on income fundamentals to drive returns. In our baseline, multifamily and office properties are expected to experience declines in NOI growth over the near term, while industrial and retail properties are projected to maintain positive NOI growth in the mid-single-digits next year.
Property values are expected to turn the corner in 2025 as diminished uncertainty, lower interest rates and inflecting NOI spur increased buyer and lender conviction, which will help to launch more fluid transaction activity. Dry powder targeting CRE investments continues to accumulate, particularly across opportunistic and value-add strategies, so capital will be deployed for the right opportunities. In terms of asset allocation, industrial and multifamily properties remain the most favored product types, which will support lower cap rates than those for the office and retail sectors. Offices have broadly fallen out of favor given rising vacancies and obsolescence, but the sector’s dislocation both from a fundamentals and capital markets perspective is likely to offer unique buying opportunities as distress unfolds. The story is far from one dimensional, though, as top-end product is positioned to outperform and garner a distinct premium over all the rest, emphasizing that even the most challenged of sectors offers a wide range of investment strategies to deploy in the chapters ahead.
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 (on right), we show the cumulative forward returns of an investment made in the fourth quarter of 2023. Over a 10-year horizon, an investor with a diversified portfolio of CRE assets would benefit from post-downturn tailwinds, subsequently realizing total returns that are attractive across the cross-asset class spectrum. While the 10-year total (unlevered) return is less than the historical average—shown on the left—this is in part because the forecast includes a period of downward pressure on pricing and appreciation returns and because cap rate compression thereafter will be moderated by higher Treasury rates than in the prior cycle.