What funny times in which we live; an observation perhaps highly dependent upon your notion of fun.  Maybe curious is the better description.  Daunting?  Frightening?  Opaque and unknowable?  All probably good descriptions.  True of politics.  True of business. 

Sticking to business, it’s hard to get conviction around anything right now.  Nonetheless, we must.  Everyone needs a view as to where our business world is going, a base case, something on which you would be prepared to invest time, energy and treasure.  It’s simply untenable to merely observe that things are pretty screwy out there and shrug.  The lack of a view on where the economy is going and how to conduct business in this current environment is, in effect, a commitment to let unreflective inertia be your guidepost and that’s not a good idea.  (I’d use pococurante, but that’s a silly fifty cent word, so I won’t.)

As this difficult year has progressed, questions remain:  Which strategies are viable and which are not? 

In figuring it out, the problem is trying to square the circle of disparate and conflicting data.  Are there discrete events, phenomena that will shape commercial real estate markets going forward?  Are we looking for a single tell?  We just concluded (for the moment) another debt ceiling crisis and while it dominated the media news cycle, it was seen, correctly, by the markets as slightly unserious.  Markets didn’t move, even though it sounded scary.  If the threat of a sovereign default by the United States didn’t change market dynamics, what will?  (Maybe the sale over these next 3 months of $1 trillion of fresh government debt will?) 

Discrete phenomena, apparently even really bad ones, rarely result in secular changes to our economy.  It’s changes in the underlying substructure of our market, the plumbing if you will, that affects change and that’s where we need to look to try to understand where the commercial real estate markets are going.  Great Man Theory doesn’t cut it. 

Right now, we have an unstable stasis.  It looks like it wants to go somewhere, but it isn’t sure where.  Nothing’s transacting, nothing’s getting resolved.  There’s little price discovery in the capital markets.  Transactional volume is low and while we see periodic bursts of transactional activity, suggesting directional change, like the flashing of a lonely lightning bug on a dark night, it’s just that… lonely.  There’s little evidence that things are changing, that things are resolving themselves and that there’s a new normal on the horizon. 

Where to look for answers?  Does the broader corporate market provide guidance?  The stock market is trading in a tight range with apparently little conviction that things are getting better, or, indeed, worse.  Another earnings season suggests that many companies are continuing to do just fine, notwithstanding all this talk of recession.  Job creation is surprisingly good.  Talk about a high employment recession abounds.  That does sound fundamentally silly, doesn’t it?  It would be fair to say that the performance of corporate America does not a compelling narrative make. 

Do other economic data provide a real tell?  Do we find it in the path of our GDP?  Q1 GDP was above long-term trends and the early indications is that Q2 might be as well.  Many economists, including those of the Fed, are expecting GDP to grow, albeit slightly, in Q3.  Take any 10 PhD economists and 6 will predict recession right now and 7 will predict a return to robust growth after a brief interregnum.  Amongst those who see recession, they’re broadly split between deep and shallow (with a bit of a bias towards shallow).  At the margins, a return to modest growth versus a continued desultory retreat into a recession will impact the commercial real estate business, but not that much. 

How about inflation?  Headline numbers are coming down.  While there are innumerable ways to measure inflation, including the egg price index, all suggest that inflation is coming down a bit, but it’s still too high.  As I write this, the Fed just announced a pause on Fed funds while they await new data before the July meeting.  Do they see new data arriving in the interim which will provide answers or is this just the equivalent of can-kicking? 

My premise here is that none of that actually matters a lot.  It’s largely, almost exclusively, interest rates that are set and controlled by the Fed and Treasury that actually matters for where our CRE economy is going.  Everything else is largely noise. 

The forward curve, where people make bets with real money, suggest that some considerable money thought, just weeks ago, that the Fed funds rate would begin to move down soon and be materially lower sometime in early 2024.  That looks a bad bet now.  That also seems to have been the weight of the views of the PhD crowd, although I don’t see anyone predicting that interest rates will anytime soon get back to a level in which legacy deals will once again perform.  (Please, Dear Lord, protect us from the zero bound.  That should not be anyone’s idea of a new normal!)

Here’s a cross sample of views interest rates:

  • The Philadelphia Fed sees the core CPI dropping to 3.6% in Q3.
  • The MBA continues to forecast a 3% flat ten-year in the fourth quarter and a 4.375 fed funds rate.
  • Wells Fargo is looking for a fed funds rate slightly below 5% by Q4. 
  • Chatham Financial, which probably has more visibility into these markets than virtually anybody, sees one-month term SOFR below 5% by Q4.
  • Several Federal Reserve committee members have mused about a pause at the June meeting, while others have continued to support significant increases until evidence of falling inflation is more palpable.  JPMorgan Asset Management sees a fed pivot as early as September and rates dropping throughout the fall. 
  • Goldman Sachs expects core PCE inflation to fall to 3% by December. 

And, of course, the Fed just paused. 

There is an endless babble of opinion around the future course of interest rates; it is fascinatingly non-homogeneous.  There’s no consensus about almost anything out there. Those who pay attention to these things are all looking at the same data and coming to widely disparate answers.  How comforting is that? 

But you gotta pay your money and take your chances.  You, too, can be an opinion purveyor!  All you need is an indurate tolerance for embarrassment and a pen (guilty). 

The structure of US interest rates is a construct, the price of money is directly or indirectly manufactured by the Fed and the Treasury.  Adam Smith need not apply.  Market forces are suppressed by government policy choices.  And so, the movement of “market” interest rates are largely decoupled from the presence or absence of GDP growth or subsistence, the presence or absence of a recession, and perhaps surprisingly, largely decoupled at least for a time, from the actual inflation data. 

Interest rates, neither floating and fixed, will materially retreat within the next 18 months to two years.  (By the way, for this purpose, my definition of material is a large enough change to make legacy commercial real estate assets, acquired, underwritten and financed before the Fed funds runup actually anywhere close to penciling.) 

One reason, and perhaps the most important reason for this sticky high interest rate environment is that Fed fund’s policy is as much politics and personality as it is driven by technical analysis. 

The Fed has made it absolutely clear that fighting inflation is its top priority.  As someone said the other day, we need to stop reading between the lines and actually read the lines.  It’s clear that the Chairman, with an excellent grasp of history, understands it’s better to be Paul Volcker than William Miller.  Mr. Volcker made it okay to crush the economy in service of taming inflation.  He’s famous and honored.  His predecessor made, what I’m sure was an honest and thoughtful decision, to step off the brake when the economy began to shudder and his reputation is, shall we say, somewhat tattered.  Mr. Powell is going to be Mr. Volcker, not Mr. Miller.  It is absolutely certain that we will overshoot, stomping on the inflation carcass long after it’s dead.  We’ll probably find out sometime in the next few years that the rapid increase of the Fed funds rate over the past year was a huge policy mistake, the lag having come home to roost.  But that’s a different story.  In any event, interest will not move down far enough to matter within the next 18 to 24 months, even in the face of considerable evidence that inflation is diminishing.  (Note that in the Fed’s June meeting commentary, they essentially said that the Fed’s expectation is that short-term interest rates would stay in the 5+ region well into next year.  Yikes!)

Elevated interest rates are a triple whammy for our biz.  First, coupons are troublingly high.  Little acquired or financed before the runup in Fed funds will pencil.  Little will pencil without significantly repricing assets.  Second, elevated interest rates crater the value of legacy financial assets.  That impairs bank capital, reinforcing the political and regulatory narrative that bank regulation must be made more assertive.  For our purposes, “assertive” is a euphemism for don’t-lend-much, significantly increased credit standards, and, oh by the way, don’t lend much money.  Between the impact of CECL, all the new enhanced capital rules (FRTB, etc.), and the very real examination pressure of the regulatory authorities, capital available for lending will be suppressed. 

Finally, banks, and to a certain extent even non-banks, are and will be compelled to preserve and demonstrate liquidity, manage risk-based capital and prove up asset values, causing lenders to shed assets, an exigency that in turn puts additional downward pressures on asset values in a very unvirtuous circle sort of way.  Distress begets distress. 

So, that’s my base case; the immediate future looks a lot like today.  A whiff, for a period of time of stagflation, at least in the CRE marketplace.  Very sticky high interest rates and high cap rates.  Restrained liquidity.  That means very difficult conditions in the commercial real estate for the foreseeable future.  A CRE recession, if you will, largely untethered to the path of the broader economy.  Our CRE recession will not end until assets are repriced and liquidity rebounds, a notion captured in the phrase “stay alive till ‘25”. 

But, blessedly (at least for me), we will see some increase in transaction velocity this year and early next.  Fed funds are now beginning to peak in the mid 5% range, and maybe that provides a certain amount of predictability, even if the landscape continues to look dire.  As market perceptions begin to change, as market participants become reconciled to the new normal, people will begin to transact (not much of a choice really).  Gone will be the fantasy that the zero bound (or something like it) is coming back.  Gone will be a notion that sub four cap rates across all market sectors will again be a new normal.  Gone will be the notion that liquidity is cheap and easy.  Assets will be repricing; strategies of hope collapse.  Compelled transactions will abound.  Many legacy loans will default as sponsors are either unable or unwilling to infuse additional capital.  We will see what we used to call “jingle mail” (keys in envelopes sent back to lender).  Buyers and sellers who have remained far apart on their notions of value will begin to confront reality and some deals will get done.  Owners of property and lenders will shed assets where there is no visible path back to viability.  Distressed debt securitizations will again be a thing. 

This is all about repricing assets and right-pricing assets must occur for our market to be restored to health.  Remember, generally there are no bad assets, just bad pricing. 

This is the path on which our markets will be restored to health.  As interest rates first stabilize and then slowly come down, confidence in the future begins to have a positive impact on cap rates and liquidity.  The Fed will eventually (certainly far too late) take its foot off the brake.  It’s going to take a while.  There will likely be plenty of false dawns, a notion captured by something one of my old friends (thank you, Joe Franzetti) said years ago during the GFC, while we may be out of the woods, we may discover the woods end at a cliff.  Restoration of a market that looks something like 2015 through 2020 will probably require more patience than most of us possess or can afford.  In the meantime, embrace reality and look for opportunities.  (There’s really nothing else to do.)