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Industry Analyst Advises Dealmaking Sooner Than Later

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As we progress through 2025, commercial real estate (CRE) investors are presented with a dynamic market landscape. While some may hesitate, industry experts suggest that now is an opportune time to engage in dealmaking.

Rising Treasury Yields and Market Volatility

John Chang, Chief Intelligence and Analytics Officer at Marcus & Millichap, highlights several factors contributing to increased pressure on the 10-year Treasury yield. These include Moody’s downgrade of U.S. credit, financial market volatility, and broad-based uncertainty. Additionally, the Congressional Budget Office projects a $1.9 trillion increase in the federal deficit for 2025, necessitating increased Treasury issuance. Chang advises that investors consider locking in loan rates early to hedge against potential increases.

Shifting Dynamics in Global Capital Flows

International demand for U.S. Treasuries is waning, with countries like Japan and China reducing their holdings. This shift, coupled with the Federal Reserve’s reduction of its balance sheet, may lead to higher interest rates. For sellers, rising rates could push capitalization rates up, potentially eroding property prices. Chang cautions that waiting on the sidelines might not be advantageous, as there are still opportunities for positive returns through property upgrades and management improvements.

Strategic Approaches for Investors

To navigate the current market effectively, investors should focus on value creation through property enhancements, management improvements, and strategic tenant mix adjustments. These strategies can yield positive leverage and returns over a relatively short time span.

In conclusion, while the market presents certain challenges, proactive and strategic dealmaking in 2025 can lead to favorable outcomes for commercial real estate investors.

 

Source:  GlobeSt.

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Treasury Yields May Keep Rising And That Is Worrisome

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You’ve managed to stay afloat through property challenges, avoided an immediate refinance, and waited things out. Then, the Federal Reserve made its third interest rate cut this fall, bringing hope that a little more relief might be on the way.

But recently, the Fed has signaled it will likely slow the pace and timing of rate cuts in 2025. This is unwelcome news for those seeking bridge or construction loans.

What does this mean for commercial real estate (CRE) mortgages? If T. Rowe Price Chief Investment Officer of Fixed-Income Arif Husain’s outlook holds, there may be more bad news ahead. In a recent report, Husain pointed out that U.S. fiscal expansion and potential tax cuts, coupled with a strong economy, are likely to push Treasury yields higher. He predicted that the 10-year yield could hit 5% by the first quarter of 2025, with the possibility of rising to 6%. This past Wednesday, the 10-year yield climbed to 4.5%, a level not seen since May 2024.

Rising 10-year yields signal greater risk-free long-term returns, which will likely lead lenders to increase CRE mortgage rates.

Husain identified six factors contributing to higher rates, but overall, he believes four of them will outweigh the other two.

The first four factors supporting higher rates are:

  1. U.S. fiscal expansion: With a budget equaling 7% of GDP and the Trump administration pushing for tax cuts, reducing the deficit seems nearly impossible. This will force the Treasury Department to issue large volumes of debt, which, when combined with similar actions by other countries, will flood the market. The increased supply of bonds will create pricing competition, and as bond prices drop, yields will rise.
  2. Decreased foreign interest in Treasurys: Countries like China and Japan have been reducing their holdings, leading to diminished demand. This reduced demand, alongside the increased supply of bonds, will lower bond prices and drive yields higher.
  3. A healthy U.S. economy: There is little indication of an imminent recession, meaning the economy is unlikely to cool down enough to reduce yields.
  4. Potential for inflation: While the Fed expects inflation to cool to 2% by 2027, tax cuts could inject too much capital into the system, raising prices. Additionally, tariffs could have a regressive effect, making goods more expensive.

However, there are two factors that could temper this outlook:

  1. Fed bank regulation guidance: New regulations could boost demand for Treasurys by banks, which might absorb some of the slack in demand, supporting prices and controlling yields.
  2. Political uncertainty and Fed actions: The political landscape has cleared with the upcoming election, and there are concerns about the Fed becoming less independent. This could encourage the central bank to slow or even stop quantitative tightening, potentially restarting bond purchases.

Despite these counterarguments, Husain concludes that longer-term Treasury yields are likely to rise, steepening the yield curve as the economic and fiscal conditions continue to evolve.

 

Source:  GlobeSt.

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Have Cap Rates Peaked?

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.

cap rates graphTreasury 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

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Bond Investors Worry About Government Debt And That’s Bad For CRE

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Pressure has been building over inflation expectations. When will the Federal Reserve cut interest rates? How long before CRE could return to, if not to a zero-rate policy, then closer to the pre-pandemic situation?

But another storm is on the horizon, one that some have been warning about although they’ve been largely ignored. The issue is the level of government debt, which is up to almost $34.6 trillion according to the non-partisan nonprofit Peter G. Peterson Foundation. The reason is structural factors, such as a large aging segment of the population, rising healthcare costs, and government spending that doesn’t bring in enough taxes to pay for what Congress authorizes.

Deficit spending requires more borrowing through government debt instruments as Reuters reports.

“Investors are bracing for a flood of U.S. government debt issuance that over time could dwarf an expected rally in bonds, as they see no end in sight for large fiscal deficits ahead of this year’s presidential election,” they wrote.

The mechanism that worries them is straightforward. There are three methods the U.S. government can use to obtain revenue to pay for its obligations. One is through taxes, but the amount brought in isn’t close to what is needed. The second is by printing money, which would eventually generate inflation. Third is borrowing, the approach the U.S. has used for generations.

Borrowing dynamics follow basic economics keeping one dynamic in mind — bond prices and bond yields move inversely. The more demand there is from those who want to lend the U.S. money by buying bonds, the lower the yield the government has to offer. The more debt the government wants to sell — that is, the more supply— the higher yields need to be to attract buyers. Also, the more the U.S. presents as a risky borrower, the greater the yield lenders/buyers will demand, and the more the government has to borrow, the riskier it seems.

Benchmark 10-year Treasury yields, now at around 4.4%, could go up to 8%-10% over the next several years, Ella Hoxha, head of fixed income at Newton Investment Management, who favors short-term maturities in Treasurys, told Reuters. “Longer term, it’s not sustainable.”

Meanwhile in some quarters concerns are reaching nightmare proportions. Jeffrey Gundlach, the CEO of investment management company DoubleLine Capital, is afraid the growing debt burden of the US government could eventually lead to a restructuring of US government debt, which would be unprecedented.

The world would likely see debt restructuring as an admission of problems and greater risk, increasing yields even more.

The bottom line for CRE: higher yields on the 10-year and SOFR — and both are strongly correlated and baselines of loan rates — would force real estate borrowing rates up.

 

Source:  GlobeSt.

 

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Treasurys Get Harder To Sell And That’s Not Good For CRE

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In the latter half of last week, yields on Treasury 10-years jumped, hitting 4.55% on Wednesday, moving to 4.56% on Thursday, and dropping down to 4.50% on Friday. By the end of Monday, it was 4.63%

If you ignore 2023 when rising interest rates had a heavy impact on Treasury yields, the last time the 10-year was in this range was in the fall of 2007, as the initial rumblings of what would become the Global Financial Crisis.

Markets are not seeing the trembling of an out-of-control housing market and the derivatives built on top of it. But the current shakings might be worse.

“A series of weak auctions for U.S. Treasurys are stoking investors’ concerns that markets will struggle to absorb an incoming rush of government debt,” the Wall Street Journal reported. “A selloff sparked by a hotter-than-expected inflation report intensified this past week after lackluster demand for a $39 billion sale of 10-year Treasurys. Investors also showed tepid interest in auctions for three-year and 30-year Treasurys.”

The worry among investors is that if inflation doesn’t continue to sink, the Federal Reserve will keep interest rates where they are now rather than start cutting as investors have wanted. Or maybe increase rates if they decide it’s necessary to break the back of rising prices.

May will bring another $386 billion in bond sales, and, as the Journal notes, this will continue no matter who is elected president in November. The first quarter of 2024 saw the Treasury sell $7.2 trillion in debt. Last year, the government issued $23 trillion in Treasurys, “which raised $2.4 trillion of cash, after accounting for maturing bonds.” But a number of Treasury auctions did more poorly than expected. The Treasury Department decided to push short-term instruments as the Fed encouraged the idea that eventually they would cut interest rates. That would make higher-rate Treasurys more valuable in a presumed near term.

With inflation started to strengthen again, that strategy becomes less appealing to buyers. Also, the Fed has said it will slow quantitative tightening, which is how it reduces its balance sheet holdings of Treasury instruments. Tightening expects that investors would buy more debt. As the Fed reduces tightening, the government might lower its expectations of how much investors needed to buy.

From a CRE perspective, the more debt on sale, the greater degree that circumstances invoke the law of supply and demand. Prices will likely drop to get enough investor purchases, which would send yields up as the two aspects move inversely. The 10-year yield is one of the standard baseline rates used in CRE lending. The other, the Secured Overnight Financing Rate, or SOFR, is strongly correlated to the 10-year, though often with a timing gap.

If baseline rates go up, so do borrowing costs, which is the big problem faced by many with maturing loans and who need refinancing but who based their business case on low interest rates and high leverage that are no longer available.

And then there is the psychological factor. All investors, whether individuals, organizations, or sovereign states, are under the thumb of human emotion. The more risk they perceive, the more skittish they are as buyers, which could push down Treasury prices even more, driving up expected yield and negatively affecting CRE.

 

Source:  GlobeSt.

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When Is The Yield Curve Finally Going To Normalize?

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Bond traders are getting certain that a long-time aberration in how Treasury bond prices and yields work is about to head back to normal.

They expect that the yield on the 10-year Treasury will rise above the 2-year (though academics often monitor the 3-month and the 10-year), Bloomberg reports.

A look at the numbers at the Federal Reserve Bank of St. Louis’ FRED website shows that July 5, 2022, was when the yields on the 2-year and 10-year Treasurys were the same. Since then, the 10-year sunk below, and there’s been an inverted yield curve. The 3-month and 10-year difference inverted on October 25, 2022. A long haul, either way you look at it.

Inversions lasting for an extended period are generally taken to mean that there’s a recession on its way … eventually. As US News & World Report noted last year, the average time between an inversion and a recession is 12 to 24 months, although the shortest period in 2019 was six months.

The theory behind the yield tea leaves is that investors are sure there’s a recession coming and so they lock in even at lower rates now because they’re sure the Federal Reserve will cut rates to stimulate the economy, making Treasury yields drop.

Harley Bassman, a big name in bonds, told Bloomberg earlier in the month, “It’s done. Stick a fork in it, man. The 10s aren’t moving.” Instead, he expects yields on the short end of the curve to drop and normalize the yield curve.

Kathryn Kaminski, chief research strategist at AlphaSimplex Group, told Bloomberg, “The question we are asking – given the wide range of outcomes – is what is that steeper yield curve? Is that going to be cuts on the short end or could it possibly be, unexpectedly, that we see weakness in long-term bonds and we have a longer time to wait for cuts – and we actually see a steepening from the long end.”

Bill Gross, another bond expert, said on social media that the Treasury 10-year with a 4% yield, around which it has lately hovered, is “overvalued.” Jeffrey Gundlach, founder, CEO, and chief investment officer of Doubleline, a money management firm that is a big player in the bond market. He said in a December 2023 CNBC interview that when the yield level of the 10-year Treasury market goes below 4%, it sounds “almost like a fire alarm” and that the 10-year yield would drop to the low 3s by sometime this year.

“In normal times it’s the short rate that comes down sharply given a recession is coming, and that causes the dis-inverting,” said Tobias Adrian, director of the International Monetary Fund’s monetary and capital markets department, told Bloomberg. “But now the US is likely to have a soft landing and so basically the curve could just flatten.”

But then, the 10-year yield has been climbing a bit over the last week, the 3-month has been steady, and the 2-year has been increasing. Some of the prognosticators will be right, others will be wrong, unless things manage to stay in a rough limbo, leaving everyone wondering. But there’s no definite answer right now.

 

Source:  GlobeSt.

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