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Say goodbye to compressing cap rates

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Inflation firming, raising possibility of more rate hikes

As we expected, inflation in March continued to accelerate. While the monthly price index technically contracted due to falling energy prices, the underlying trends continue to show inflation heading upward. The headline consumer price index (CPI) grew by 2.4 percent on a year-over-year basis, up from 2.2 percent in February. Despite the falling energy prices, year-over-year headline inflation increased due to the significant decline in wireless phone services in March of last year. Meanwhile, core CPI also accelerated to 2.1 percent year-over-year, up from 1.8 percent in February. But more importantly inflation has been ramping up in more recent periods – the core CPI has increased 3.0 percent on an annualized basis in the first quarter of this year, the fastest quarterly rate since the second quarter of 2006. And the produce price index (PPI) accelerated faster than anticipated. The headline PPI grew by 3.0 percent year-over-year, up from 2.8 percent, while the core PPI grew by 2.7 percent year-over-year, up from 2.5 percent. 

Although the personal consumption expenditures (PCE) index remains the Fed's preferred measure of inflation (and it remains relatively tame), taken together these other data points reaffirm the Fed's belief that the economic situation continues to improve and that underlying inflation is accelerating. The Fed's minutes from its March 20-21 meeting confirm this.

This increased optimism will provide the Fed with enough cover
to hike rates at least two more times this year and the possibility
of three more hikes continues to increase. 

Interest rates reflecting underlying reality

Increasingly, interest rates are reflecting the underlying economic reality despite temporary disruptions from political and geopolitical noise. The 10-year Treasury yield remains locked in a trading range between roughly 275 and 295 basis points, waiting for a catalyst to surge higher. Meanwhile, rates at the short end of the curve are moving higher along with inflation and Fed tightening. Consequently, the yield curve continues to flatten as we anticipated with the 2-year Treasury yield reaching its highest level in roughly 9 and a half years. Further Fed tightening should cause the yield curve to continue to flatten this year.

Consumers still optimistic despite trade tensions            

Trade tensions appear to have fallen off the radar screen a bit after Chinese President Xi tried to deescalate tensions. But U.S. consumers noticed the increasing hard feelings making them feel less optimistic in April.

Consumer sentiment remains at elevated levels, but
the decline from March was greater than anticipated

We do not expect the bad tidings to last, not just because trade tensions could ease, but also because some consumers should start seeing larger paychecks and their annual tax refunds.

What it means for CRE

With inflation heading upward, interest rates are sure to follow. We reiterate that in the short run, increasing rates should not have much impact on commercial real estate (CRE) cap rates and valuations. But over time the cumulative impact of increasing rates will eventually impact pricing. Property market fundamentals continue to support valuations – for now – but rent growth is slowing and vacancy rates are drifting higher for a number of major property sectors. In a general sense, cap rate compression has already stalled out and investors appear to be more cautious at this relatively late stage of the cycle after so many properties have already traded. Even if volume rebounds a bit in 2018, the risk premium compression cycle has likely slowed if not ended.  The forces holding cap rates down will not do so forever. Secondary markets appear more vulnerable and could see cap rate increases before the primary, institutional markets do. Forward-looking investors should keep their eye on this dichotomy.

What we are watching this week

Retails sales for March should show a healthy gain, fueled by tax refunds and the impact of the tax cuts. This will follow a few months of disappointing results so a bit of catch up should occur as well. Housing starts and building permits for March should both also rebound a bit after hitting a rough patch, although wintry weather during the month could wreak some havoc with the data.

Thought of the week

After accounting for changes in family size, government benefits, and taxes, the Congressional Budget Office found that all income groups have achieved significant real (post-inflation) income gains since 1979.

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