Flash Call Recording
Interest Rates, the Election & the Cycle
November 8, 2018
Flash Call Summary
2018 midterm election and the market
Interest Rates, the Election & the Cycle
The 2018 midterm election did not materially change the outlook for commercial real estate. The result—a divided Congress with the House now under Democratic control and the Senate remaining under Republican control—is considered a favorable outcome by many market participants and was widely expected.
The effects of existing policies will continue to bolster economic and market performance. For example, the Tax Cuts and Jobs Act of 2018 will fuel new investment through the creation of opportunity zones. Beyond the legislative agenda, the regulatory environment—important for both business sentiment and financial conditions—will not materially change as it is largely overseen by the executive branch.
Infrastructure spending appears to be one area of bipartisan support, which would bolster real estate fundamentals by spurring additional investment in the market.
In terms of potential risks, fiscal policy will become more complicated. The debt ceiling was suspended only until March 2019, meaning the government's ability to borrow could be impaired after that date until the suspension is extended. Additionally, spending caps mandated by the Budget Control Act of 2011 will take effect in fiscal year 2020, absent a new budget agreement. Battles surrounding these two issues—even if they are ultimately resolved before deadlines—are likely to at least temporarily weigh on market sentiment and create some volatility. If they aren't resolved, they have the potential to impact economic and market fundamentals.Trade policy is another area to watch because it has the potential to impact the cost of consumer goods, materials (construction costs) and, by extension, the cost of doing business and real estate market fundamentals. With that in mind, ratification of the U.S.-Mexico-Canada Agreement (the new NAFTA) is still expected, due to its importance to the U.S. economy and congressional districts across party lines. In terms of trade disputes, particularly with China, the election is unlikely to significantly impact the U.S. approach to bilateral trade issues. Recent reports are that trade talks with China have resumed ahead of the G-20 summit in Argentina later this month. This raises the possibility that an agreement of some sort may be reached.
Interest rates and the market
The capital markets landscape in 2018 has been remarkably resilient, diverse and robust. This is notable given three Fed rate hikes (with a fourth hike likely in December), flattening yield curve, a recent spike in the 10-year Treasury yield and two stock market corrections (one in February and another in early October).
The resilience of the market is evident in the continued healthy volume of commercial real estate investment. Excluding large entity-level deals, investment volume is up 5.5% year-over-year (up 10.6% including entity transactions). Capital flows remain strong and should continue driving transaction activity. There is abundant debt availability and, regarding multifamily, GSE caps for 2019 will remain close to 2018 levels. Furthermore, all of this is underpinned by a strong economy.
Looking at the rate environment, the 10-year Treasury yield currently stands at 3.1%, up nearly 70 basis points this year. The one-month LIBOR—currently at 2.3%—is up by approximately 75 basis points. Meanwhile, the yield curve has trended flatter during much of 2018, which has caused concern for many market participants given its historic ability to predict recession.
The rise in interest rates is due to healthy economic growth in the U.S., which is outperforming other developed economies. U.S. GDP grew by 3.5% on an annualized basis in Q3. Other signs of economic strength, such as consumer confidence and increased wages (3.1%), are further signs of a healthy U.S. economy. Global economic growth—although showing some signs of cooling off recently—remains healthy. These factors support higher interest rates. From a commercial real estate perspective, many investors have modified their debt strategies by either decreasing term or having longer interest-only periods to mitigate the rising cost of the base rate of debt.
In terms of expectations, healthy economic conditions will allow the Fed to continue gradually raising the federal funds rate. CBRE expects the rate to reach 3% by the end of 2019, before peaking at around 3.5% sometime in 2020.
Looking at the 10-year Treasury, yields have been hovering around 3.2% recently. Barring a spike in wages or some other unexpected rise in core inflation, the 10-year Treasury yield will likely peak near 3.5%.
What does all this mean for cap rates? There are seven variables that affect them:
2. Treasury yields
3. Spread between AAA corporate debt and Treasurys
4. Lending momentum
5. Strength of the U.S. dollar
6. Rate of unemployment
7. Fed balance sheet
Primary factors putting upward pressure on cap rates include rising Treasury yields, potential easing of lending momentum, reduction in the Fed’s balance sheet (aka quantitative tightening) and a strong U.S. dollar.
Conversely, factors supporting cap rate compression include inflation and falling (already low) unemployment rates. Inflation feeds through to rents and falling unemployment rates are indicative of strong demand and a healthy economy. These two factors are significant and support cap rate compression.
On balance, CBRE foresees a stable cap rate outlook in 2019. This is due to the balancing out of the factors that are putting upward and downward pressure on cap rates.
In summary, it is likely that neither the election nor the recent rise in interest rates will change the near-term outlook remains positive. Additional rises in interest rates can be expected but they will be balanced by healthy economic growth over the near term.