Research

Economic Insights:
An analysis of the
CRE capital markets

Investors are looking for clarity in the slowing economy and falling interest rates, pondering what it means for CRE capital markets.

August 13, 2019

While the economy is holding up well, the deterioration in markets could likely force the Fed’s hand into making more rate cuts. 

An analysis of the CRE capital markets

Data released last week supported our thesis that economic growth is slowing but that the economy remains on solid ground. The ISM nonmanufacturing index for July declined, in line with our expectations, falling to its lowest level in roughly three years. While the services sector of the economy remains insulated from trade-related economic headwinds, it cannot completely avoid them. 

Weekly jobless claims for the week ending August 3 ticked down to an almost four-month low. Meanwhile, job openings changed little at 7.35 million. Although the number of open jobs has declined since February, openings remain at elevated levels indicative of a strong labor market. 

And inflation, measured by the producer price index (PPI) for July, showed headline inflation holding steady while core inflation surprised on the downside. Both measures now stand below 2 percent. Although not regarded as the main inflationary index, the PPI data reinforces what we are seeing in other data – a slowing but not collapsing economy. 

Non-economic events still hold sway

In news more political the economic, the U.S. labeled China a currency manipulator. We see this as a symbolic move and arguably the tariffs already imposed or threatened impart a greater penalty. But it served as a signaling mechanism for markets, which unambiguously viewed it as a negative development that likely would push the U.S. and China farther apart in negotiations. Consequently, equity markets pulled back last week while bond yields fell, and the yield curve further inverted. While the economy is holding up well, the deterioration in markets could likely force the Fed’s hand into making more rate cuts. Expectations for cuts at the September and October meetings are rising. 

What it means for CRE capital markets

For commercial real estate (CRE) capital markets, that dichotomy presents a serious issue. The economy is still faring well. Rate cuts appear driven more by political risks (notably trade) and market fallout than meaningful deterioration in the underlying economy. With rate cuts unlikely to spur economic growth and CRE fundamentals, where does that take CRE capital markets? Undoubtedly, CRE assets command high prices. But an analysis of the market leads us to conclude that assets are not overvalued. The risk premium, measured by the cap rates minus the 10-year Treasury rate, remains at healthy levels across major property types. When this premium gets too low it indicates that investors might be overpaying for assets. This occurred during the CRE bubble before the last downturn – investors were paying for too little premium relative to the risk that they were taking. We do not see indications of that now. Risk premiums remain above the levels from the bubble era and have recently trended upward. Moreover, local research intelligence on the ground is currently observing few if any signs or chatter about a bubble.

But with the Fed now on a path of rate cuts, the risk increases that a bubble forms if investors go too far. Certainly, all else equal, rate cuts should put upward pressure on prices because the decline in interest rates causes a decline in discount rates, pushing prices up. But if investors overshoot, thinking the interest rate cuts are going to spur the economy and the CRE market (which we do not believe) then valuations could rise too far and push risk premiums down to potentially problematic levels.

What we are watching this week

We expect the consumer price index (CPI) for July to show upward pressure on both headline and core prices, resulting in an acceleration in year-over-year changes. Retail sales for July should show a slight gain after a strong showing in June. And consumer sentiment for August should remain at elevated levels, reflecting the optimistic mood of consumers.

Thought of the week

As of June, the average age for cars and light trucks in operation reached 11.8 years, a record high.

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