Cap rate expansion may have very well peaked, but uncertainty will delay sales volume recovery until 2025, according to CBRE’s cap rates survey for the first half of the year.
Treasury yields remained volatile during the first half of 2024, reacting to economic data that sent mixed signals about the outlook for inflation, Federal Reserve policy and long-term interest rates. The 10-Year Treasury yield started 2024 below 4 percent and peaked at 4.7 percent in late April.
Ultimately, continued disinflation and expectations for a Fed rate cut held the 10-year Treasury yield to 4.2 percent as of June.
“Interestingly, different property types did not move in unison but rather reacted uniquely to changing fundamentals and capital markets drivers. For instance, industrial cap rates fell on average and office yields continued their climb,” according to the report.
More than 250 CBRE real estate professionals completed the survey with their real-time market estimates between May and June. The report captured 3,600 cap rate estimates across more than 50 geographic markets to generate key insights.
Every one of CBRE’s reports in the series asked respondents to estimate the direction of cap rates and the magnitude of the expected change during the next six months. This quarter, the most common response across all categories was “no change.” Fewer respondents believe cap rates will increase during the next six months compared to the previous two publications.
“This improved sentiment is likely driven by more accommodative signals from the Fed and the decline in bond yields from their October 2023 peak,” the survey revealed.
The share of respondents expecting further devaluations was highest within the office sector, reflecting the uncertainty around market fundamentals.
Buyers coming off the sidelines
Doug Ressler, manager of business intelligence at Yardi Matrix, told Commercial Property Executive that it appears that cap rates have indeed peaked but ongoing uncertainty is expected to delay sales volume recovery until 2025.
“During the first half of 2024, cap rates held steady despite fluctuations in Treasury yields,” Ressler said. “Different property types reacted uniquely to changing market conditions, with industrial cap rates decreasing and office yields continuing to rise. Most respondents in the survey believe that cap rates will remain stable in the near term.”
Peaking will differ by market and property type, Ryan Severino, chief economist at BGO, told CPE.
“There has been tentative evidence of peaking broadly, and that looks almost certain with the Fed set to start cutting rates,” Severino said. “The first-order effect of a rate cut won’t have much impact. But the second-order effect, decreasing the risk premia embedded in cap rates, should be more meaningful—especially with the record amounts of dry powder sitting on the sidelines like Pavlov’s dogs waiting for the Fed to ring the bell.”
Matthew Lawton, executive managing director at JLL, mentioned cap rates peaked in the second quarter and have a downward trend based on some recent transactions, including the KKR portfolio acquisition and other recent one-off transactions in the multifamily space.
“We are seeing a significant number of buyers coming off the sidelines due to several factors, including discount-to-replacement costs, lack of new starts that will lead to outsized rent growth and bringing in residual cap rates due to treasuries stabilizing and coming in more recently,” Lawton pointed out.
Equilibrium must avoid negative leverage
Recent data suggests there is uncertainty in office cap rates in some major markets, according to Jeff Holzmann, COO at RREAF Holdings.
He further added, “But that peak assumption is only a short-term observation since the cap rates are closely related to interest rates. The equilibrium can only survive long term as long as we are not in the zone referred to as negative leverage. This occurs when the effective cap rate is lower than the interest rate of the debt, which means that even a functioning property that is producing cash flow can’t service its own debt, not to mention profits. That’s when properties fail, loans stop, and a new equilibrium must emerge.”
“Hence the future trajectory of the cap rates in the industry will depend on what the Federal Reserve does with the interest rates in the coming months. The consensus seems to be that rates will remain steady or possibly even decrease for the first time in a long time. This suggests we may see peak cap rates for quite some time,” Holzmann concluded.
Neil Schimmel, Investors Management Group founder & CEO, noted that with inflation and debt pricing falling, cap rates are poised to follow suit.
“Loan rates have dropped 50 basis points in the past few weeks. Today’s underwhelming jobs report confirms the Fed’s success in cooling inflation. As a result, cap rates have likely peaked and will decline, though not to the lows of 2021 and 2022.”
David Camins, principal at Xroads Real Estate Advisors, told CPE that the argument could be made that cap rates have peaked in the office sector; however, they may be “the least of the worries for a potential buyer,” considering the number of lenders still not lending to the office sector.
“Anyone underwriting a loan or investment in the sector is not solely focused on a cap rate, as underwriting the cash flow for a multi-tenant office property is not as linear as it once was,” Camins said. “These days, it’s more akin to how hotel cash flows used to be underwritten.”
“Even if lease rates are relatively the same, they are materially different given the ‘new’ creativity within the concession packages. These all contribute to challenging cash flow projections, regardless of what economic factors are under consideration,” he concluded.
Source: CPE