November 28, 2016
Interest rates spiked in the aftermath of the 2016 U.S. presidential election. The benchmark 10-year Treasury stood at 2.36% at closing on November 23, up 53 bps from Election Day on November 8. How will this rapid movement impact the cost of borrowing and, by extension, capital values in commercial real estate?
While it’s too soon to determine any long-term impact of the sudden spike in interest rates, the immediate market reaction in the three weeks post-election has resulted in several instances of higher loan costs, lower LTVs, delayed refinancing activity and increased bid-ask pressure between buyers and sellers. There also is evidence of some sellers agreeing to modest price adjustments, and some transactions being terminated, though most transactions under contract are proceeding under the originally agreed upon terms. Despite some of these immediate market reactions, it is premature to conclude that there is or will be a decrease in capital values in commercial real estate.
Commercial real estate values will be affected over the next few months by many significant factors beyond just interest rates, especially the strength of funds flows from international and domestic sources. Despite recent indications that China may limit the export of capital to large foreign real estate transactions, equity capital flows from international and domestic sources still remain strong by any historic measure. Furthermore, much of the post-election expansion in bond yields is related to investor funds flow/sentiment shifts from bonds to equities, as well as into sectors expected to benefit from the new administration’s policies, including infrastructure and defense. However, investor sentiment could change (and decrease bond yields) should we see an uptick in market volatility or other geopolitical shock. In short, there are too many variables at play over the next few months to reach definitive conclusions on value today.
We will monitor market conditions closely and will produce a market report in mid-January, which will draw more definitive conclusions on any more permanent shift in market conditions.
The rapid rise in interest rates began immediately after the U.S. presidential election. As noted in CBRE’s recent MarketFlash, Implications of the 2016 Presidential Election for CRE, President-elect Donald Trump has stated policy positions to lower taxes, lessen regulation and increase spending on infrastructure and defense that could stimulate economic growth. While we speculate as to the actual impact of these policies, the financial markets clearly believe stronger growth is ahead. Several wild cards may push in the other direction, notably trade and immigration policies.
Prior to the election, higher interest rates were likely due to tighter labor conditions, wage inflation and the core PCE price index getting closer to the Fed’s targets. Given the increased post-election growth expectations, a Fed raise in December is near certain, and investors clearly believe that the Fed will act more aggressively to raise rates in 2017.
Growth expectations influence the Fed’s data-driven thinking, as well as the global implications of a strengthening U.S. dollar on emerging market currencies, many of which have already been devalued significantly post-election. Emerging market currencies are relevant, since much of the sovereign and corporate debt in these countries is priced in U.S. dollars. A rapid relative devaluation of home country currencies could severely stress the emerging-market debt market if the Fed moves too quickly. The Fed also will be conscious of the potential to invert the yield curve by pushing short-term rates up too quickly, which has long been a strong portent of a recession. In short, the immediate market reaction has pushed interest rates upward, but global events and concerns may put a damper on the rise.
- Lower Loan Proceeds. Prior to the post-election spike in interest rates, lending conditions had already been tightening in 2016. LTVs dropped from 66.6% to 64.0% between Q3 2015 and Q3 2016, with the bulk of this decrease in commercial loans. Some of this decrease is due to mounting pressure from regulators to limit more risky loans, particularly for speculative construction. With the most recent post-election spike in base rates, debt service coverage ratios may be stretched further, requiring more equity from buyers and those seeking to refinance loans. Furthermore, we have seen a 41-bps increase in spreads in multifamily and a 34-bps increase in commercial loans from Q3 2015 to Q3 2016. Some of the rate increase may lead lenders to make up a portion of the cost in the form of lower spread. We have seen some evidence of this already. As such, the coverage issue likely will not lead to an immediate dollar-for-dollar reduction in proceeds for most loans, but will negatively impact those loans and proceeds at higher loan to values.
- Fannie Mae/Freddie Mac. With rates up over 50 bps, proceeds are down for many Fannie Mae and Freddie Mac post-election loans. We have seen some immediate impact on discretionary refinancing. Some borrowers are going to the sidelines to see where rates stabilize, and others are going down the yield curve to maintain proceeds by either taking a shorter-term fixed-rate loan (seven-to-10-year term) or flipping to a floating-rate loan. We also have seen modest credit spread compression that makes up some, but certainly not all, of the interest rate rise. Mortgage liquidity remains strong for the GSEs and both should finish 2016 with $50 billion to $55 billion of multifamily loan purchases. In addition, the FHFA announced on November 22 that the 2017 volume caps for the GSEs will remain at $36.5 billion each, which sends a good signal to the market going into 2017 regarding the availability of multifamily debt.
- Change in Cap Rates/Values. For acquisitions that are under contract, many buyers are asking for—and some are receiving—a price reduction due to the rate increases, but most of these reductions are relatively modest and the majority of transactions are still proceeding under the originally agreed upon terms. Given the mixed evidence on the ground and the inconsistent historic relationship between cap rate and interest rate movement, we cannot yet conclude that there has been a lasting change in cap rates for CRE.
Longer Term: The Interest Rate/Cap Rate Question
- 2013 “Taper Tantrum.” In 2013, CBRE studied the impact of the “taper tantrum,” in which 10-year Treasury yields surged by more than 100 bps between May and August 2013. Our study found that there was minimal upward movement in cap rates, and transaction volume did not decrease. To the contrary, volumes in Q3 2013 increased [ATTACH LINK TO STUDY]. In short, while it is as yet unclear whether the most recent increase in rates will impact values, the 2013 example clearly shows that the market will look at values and cap rates on a case-by-case basis, and will not move some values at all. The findings of our 2013 study are summarized as follows:
- 10-year Treasury moved from 1.66% to 2.78% from May to August 2013.
- Less than 10% of the 347 valuations we studied during that time period showed any change in pricing pre-rate rise/post-rate rise.
- Less than 4% had a greater-than-4% rise in value, with the greatest negative impact on the office segment.
We recognize that 2016 is not 2013. While we concede this 2013 scenario is not a perfect comparison, it does provide strong evidence that drawing any short-term conclusions from an interest rate spike is very likely an over-reaction and may be incorrect. We are later in the cycle today and most rent growth expectations are softer than they were in 2013. While this is putting downward pressure on values, international capital flows are higher than they were three years ago and are pushing values in the other direction.
- Econometric Modeling. In September 2015, CBRE Econometric Advisors studied which markets might be most sensitive to movements in the 10-year Treasury. The study showed great market variability in sensitivity to upward movement in interest rates, largely based on which markets had the greatest cap rate compression running up to the increase. The study did not show the actual inflection point (when cap rates start to move in reaction to interest rate movement), but did show that cap rate expansion could be close to a one-to-one movement in those markets that experienced significant cap rate compression leading up to the interest rate spike. Markets that did not have as significant cap rate compression were much more resilient, with almost no increase in cap rates. In short, any expectation of cap rate movement must take into consideration the market, asset type and the strength of global flow of funds before reaching conclusions that an asset will be more or less resilient to interest rate increases.
While it is unclear what the impact on pricing will be over the next few months, there is mounting evidence that the election results have had an immediate impact on the behavior of some lenders (lower LTVs), borrowers (moving down the yield curve to shorter-term loans or delaying refinancing decisions) and sellers/buyers (asking for and, in some cases receiving, reductions in contract sales prices). Notwithstanding this immediate market reaction, we must consider that the move only impacted a sub-set of transactions in the market and other factors beyond interest rates will impact pricing in the short term. These factors include: the strength of funds flows from international and domestic sources, which have the potential to overcome the increased cost of debt; rental growth expectations, which, while they have softened in the past year, may strengthen again with stronger growth in the overall economy; and relative value of commercial real estate vs. other alternatives, notably corporate stocks and bonds, which draw non-dedicated real estate buyers in and out of the market. In summary, it is too soon to say whether there is a permanent shift in capital values. Any conclusions reached on the events of the last three weeks are likely premature. We will be monitoring transaction flow and will publish a more detailed report in mid-January when pricing trends become clearer.