CBRE believes that the recent inversion of the yield curve—the yield on the 10-year Treasury note dipped below that of the three-month note between March 22 and March 29—will have minimal impact on the sales or debt financing markets. Moreover, yields on the 10-year and two-year Treasury bonds have not inverted. Based on our evaluation of economic factors, historic factors and anecdotal evidence from our clients and professionals in the field, our house view remains that the next recession will not occur until late 2020 or early 2021 and may not be very long-lived.
The 10-year Treasury yield has dropped significantly since November and was below that of the three-month Treasury in the past week (2.39% vs. 2.43% as of March 28), including the following recent movement:
Down 86 bps from the high on November 8, 2018 (3.23%).
Down 65 bps since January 1, 2019.
Down 38 bps since March 1, 2019.
Figure 1: Treasury & Libor Rate History
Commercial Real Estate Implications
Based on discussions with our producers and clients and a review of closed deal data in the last few weeks, we have determined the following:
Sales/Equities: In the case of interest rate increases in the past several years, we saw very modest movement in pricing and re-trade activity for deals under contract (in the range of 1% to 3% price reductions overall). In this current instance of an interest rate decrease, the data suggests (and we would expect) no price changes. Our proprietary “Deal Flow” internal database confirms that the average cap rate of CBRE deals in the market today are almost the same as they were a year ago. Furthermore, while the recent drop in the 10-year Treasury has been significant (86 bps), it is only about 35 bps below where it was in September 2018.
Figure 2: Historic 10-Year Treasury Rate Spikes Since 1994
Debt & Structured Finance: The market remains deep and liquid but there have been a few noticeable changes to recent lender underwriting from the rapid changes in the long end of the yield curve, including:
Fixed vs. Floating: Despite the flattening of the yield curve, with short-term rates now expected to fall further and the lower pre-pay penalties of floaters, we are seeing an increased interest in short-term debt.
Floors: Several lenders are instituting floors on both the overall interest rate on long-term fixed-rate debt (approximately 4%) and some on the 10-year Treasury (approximately 2.5%). Due to competitive pressures, some lenders who have resisted floors have used this opportunity to win transactions and some have lowered them to maintain quoted rates from a few weeks ago. There seems to be a sweet spot at around five-year loan terms for the right combination of overall rate and borrower flexibility.
Spreads: While spreads increased in December and January primarily due to stock market volatility, spreads have remained largely unchanged in the past few weeks and in some instances have fallen due to competitive pressures. Fannie/Freddie spreads have modestly compressed for longer term loans (7+ years) and have remained largely flat at the shorter end.
Caps: The cost of interest rate caps (the cost of hedging floating- to fixed-rate loans) is at or near historic lows.
Construction Lending: Some banks have paused due to macroeconomic concerns as volatility creates headline risks. Non-bank financial institutions still provide great liquidity.
Macroeconomic & CRE Factors Against Recession
Despite the well-known history of yield curve inversion as a harbinger of a pending recession, there are several macroeconomic and CRE-specific factors that lead us to believe this will not happen today:
Inflation in the advanced economies, particularly the United States, continues to surprise on the downside, allowing central banks to ease policy and support growth. The Fed has been the quickest to reverse its bias to tightening, but other central banks have followed.
China has introduced a substantive monetary and fiscal boost to prevent a further decline in its economic growth rate, one of the causes of the recent yield curve inversion.
2019 will also see additional fiscal stimulus in the Euro Area, particularly in France, to boost a flagging growth rate in that region.
CBRE believes that these measures, alongside the continued strength of the U.S. economy, will be enough to put the global economy back on track by the second half of 2019.
The U.S. CRE market is much lower-leveraged today than it has been in prior market cycles and supply is in check, particularly in the office and retail sectors.
The rise of non-bank financial institutions will give the market additional liquidity, particularly in the construction sector, rather than from banks that are more dependent on the carry trade (borrowing short/lending long) than are non-bank financial institutions.