December 19, 2018

Executive Summary

  • As widely expected, the Federal Reserve increased the federal funds rate by 25 basis points today—a move that some hoped wouldn’t happen in the face of significant stock market weakness.
  • The outlook for cap rates in 2019 remains favorable, as debt and equity markets remain highly liquid and CRE fundamentals remain good (retail, office, multifamily) to strong (industrial). Furthermore, the Fed’s softening outlook should give investors confidence despite strong but slowing rent growth.
  • Today’s decision was supported by healthy economic data, though the Fed slightly softened its GDP growth expectations to 3% for 2018 and 2.3% for 2019.
  • The Fed softened its outlook on rate hikes in 2019 by indicating it only expects two rate increases next year, rather than the three it previously projected. Additionally, the Fed voiced a more nuanced position today regarding the need for additional hikes and stated it will monitor global economic and financial conditions.
  • This was the fourth rate increase this year and the ninth since the Fed began raising rates in 2015. The targeted range for the federal funds rate now stands at 2.25% to 2.50%.
  • Rate hike expectations in 2019 further weakened in recent weeks as a global economic slowdown in the third quarter, ongoing trade disputes and significant bond and stock market volatility have clouded the growth forecast and lessened inflationary concerns.

Fed Policy Stance & Outlook

The Federal Reserve increased the federal funds rate by 25 basis points (bps) today to a range of 2.25% to 2.5%. This was the fourth quarter-point increase in 2018 and the ninth since late 2015. In addition to the short-term rate hike, the Fed is continuing to shrink its balance sheet by $50 billion per month in a further tightening move.

These moves are designed to shift the central bank away from its extraordinarily accommodative post-recession policy stance in response to improving economic conditions. Despite these tightening moves, the Fed altered its outlook for 2019 today by, projecting only two hikes next year instead of three. Nuanced changes to the FOMC’s statement today included replacement of the word “expects” with “judges” that additional rate hikes will be appropriate. Language was also inserted stating that the FOMC sees balanced risks to the outlook, “but will continue to monitor global economic and financial developments and assess their implications for the economic outlook.”

U.S. GDP growth remains strong and is expected to be near 3% in 2018, with the current Fed Nowcast of Q4 GDP growth of between 2.4% and 2.9%. The Fed slightly softened its GDP outlook to 3% growth this year and 2.3% in 2019. With an average of 170,000 jobs created in each of the last three months, job growth has exceeded expectations with the lowest unemployment rate since the late 1960s. The Fed’s preferred inflation measure is near—though most recently, slightly below—its target of 2%, giving the Fed further data-driven reasons to slow the pace of future rate increases. Wage inflation is slightly elevated at 3.1% in November, which has given Fed hawks concern.

Despite the dovish tone of the Fed’s recent statements and today’s FOMC release, many market participants have wanted an even more accommodative approach. Recent stock market volatility, indications of softening economic conditions abroad (see CBRE’s recent MarketFlash on global economic growth) and collapsing oil prices are clouding the outlook for future rate hikes. As a result, the market is now pricing in a significant possibility of no further rate hikes in 2019. Positive surprises in 2019—especially a settlement of the U.S. and China trade dispute, a reasonable Brexit deal and a turnaround in EU growth—could change the Fed’s view on a pause in tightening and put it back on a more restrictive path (more rate increases).

Implications for CRE

The strength of the U.S. economy supports commercial real estate fundamentals across all property types, though late-cycle factors are negatively impacting some asset types—particularly rising labor costs that are impacting both new construction and tenant improvement allowances. Income returns are expected to remain steady in 2019, but total returns are expected to continue their recent downward trend as appreciation gains slow.

The Fed’s pause should allow cap rates to remain relatively flat in 2019. Nevertheless, late-cycle concerns are making investors more skeptical of assets that have material flaws from a fundamental or liquidity perspective (i.e., more upward pressure on cap rates of lower quality assets).

Despite these late cycle concerns, the volatility in the stock and bond markets makes commercial real estate even more attractive as a long-term capital strategy and we expect the spread between bonds and cap rates to further compress if this volatility persists. As investors seek yield in any flavor (stocks, bonds, real estate, other alternatives), U.S. commercial real estate will remain an attractive place to deploy capital.

Healthy U.S. economic conditions support today’s rate hike, as well as commercial real estate fundamentals. We believe the Fed may pause interest rate hikes in 2019 until the U.S. and global outlook becomes clearer. U.S. commercial real estate as is expected to benefit from both the more dovish Fed and the volatility that is making stocks and bonds less attractive.

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