U.S. MarketFlash | Debt Capital Market Resilience in the Face of Volatility

June 27, 2019

Executive Summary

Macroeconomic View Volatility related to trade, along with slowing growth in China, the EU and recently the U.S., has caused the 10-year Treasury rate to fall by more than 100 basis points (bps) since November to just over 2%.
Fed Watch: These conditions and tempered inflation have caused the Fed to reverse course since late 2018 from a restrictive to an accommodative stance. The market now expects the Fed to reduce short-term rates one or two times this year.
Economic Forecast: CBRE forecasts U.S. GDP growth of 2.3% in 2019, slowing to 1.5% in 2020. We expect slower economic growth than in recent years through 2024, with a low chance of an interest rate-led recession over the period. The 10-year Treasury rate likely will not reach 3.0% for at least 24 months, probably longer.
Debt & Structured Finance Outlook: Many borrowers can now can secure longer-term debt at short-term rates and have lower overall borrowing costs, including reduced cost of interest rate swaps.
Foreign Currency/Hedging: Lower U.S. interest rates relative to most foreign currencies have reduced hedging over the past three months by an average of 50 bps per year. Negative yields in some countries should also spur foreign capital flows to U.S. commercial real estate.

Sales Summary

Sales volume in 2019 has remained strong, though down slightly from 2018’s near-record levels. Investor interest remains very strong across the board and we are likely to see an additional boost by recent and anticipated Fed and interest rate movements. Based on CBRE’s proprietary Deal Flow database, we see the following trends:

Deals are on the market about 5% longer today than they were in 2018 and the number of signed confidentiality agreements per offer is down by about 10%.
Overall cap rates average about 6.52%, but there is a growing view that sellers are bringing their best assets to market. For those offerings, cap rates are down by about 20 bps from 2018.
The two hottest property sectors—industrial and multifamily—continue to have modest cap rate compression.

Bond market Indicators are positive for property values. After a significant spike in both Baa and high-yield bonds at year-end 2018, the falloff in long-dated Treasury yields has also led to a falloff in corporate bond rates. Though we have seen modest increases in corporate spreads recently offsetting some of the drop in Treasuries, Baa and high-yield bonds and relative values of total CRE returns and public REIT dividend yields are well within their historic averages, which historically indicates stability of the CRE sector in the succeeding year.

Debt & Structured Finance Summary

Borrowing costs are declining. For example, 10-year, 65% LTV loans that were around 4.5% in January are now generally in the 3.5%-to-3.75% range. Spreads for fixed-rate loans have only increased by 10 to 20 bps, so borrowers are seeing rates that can be 100 bps lower than what they were just six months ago. Despite these relatively low fixed rates, many borrowers prefer floating rate loans, as shorter-term holds and prepayment flexibility are increasingly important.
Life companies remain active lenders and are offering loans either with rate floors or index floors (for example, 10-year Treasury floor of 2.25%). Some are quoting slightly higher spreads over the base Treasury rates with no floors. Life companies’ average 65% LTV loans are in the 3.50-to-3.75% range, with best-in-class deals averaging 3.25% to 3.35%.
Banks continue to aggressively pursue deals with strong sponsorship and remain a viable option for construction lending and shorter-term deals. They have not had to deal with Treasury rate volatility, as most quote their loans over LIBOR. There has not been much change in their quoted spreads, which generally remain in the L+190- to 225-bp range, usually with some recourse when the LTV is greater than 60%.
Debt funds and private capital sources remain one of the more interesting and dynamic of all the lender types. Competition among these lenders has caused spread pricing to decrease from the high 300s to the low 200s over the past 18 months. Some deals are priced inside of L+200 and there has been increased construction loan activity at higher LTVs. These lenders continue to minimize structure and covenants on these deals to win business, with limited or no recourse and no extension hurdles. In this regard, they are putting pressure on traditional banks.
Multifamily debt capital markets are robust and very liquid with all lender types having strong demand. 2019 should be another record year for multifamily lending and may top $330 billion.
There is substantial liquidity across the capital stack for industrial product, particularly for portfolio loans, and increased activity in larger loans offering scale and diversity. Most lenders are underweighted in industrial and are trying to increase their book. Rental growth, compelling supply demand fundamentals. consistent performance and investor demand continue to propel the sector.

Economic Environment

Rising interest rates and a slowdown in China hit confidence at the end of 2018, prompting a sharp, more stimulative policy change by the Fed and the Chinese authorities. After good months in March and April, the global economy, including China, dipped in May and imports remain well below their H1 2018 levels. The obvious major new factor is the escalation of the U.S.-China trade dispute. New tariffs and the U.S.-imposed restrictions on Huawei have raised tension and corporations have reigned in their capital expenditure plans.

While consumer demand is holding up, manufacturing output is slowing or falling in many parts of the world. Consumer demand is supported by high employment rates and wage increases in many countries. Manufacturing output is being undermined by weak investment due to heightened trade-related uncertainty.

The CBRE house view for U.S. GDP growth in 2019 is 2.3%. Due to the manufacturing slowdown, we have reduced our interest rate expectations for the 10-year Treasury to end 2019 at 2.3%. CBRE also expects a cut in the federal funds rate before the end of the year and further cuts in 2020.

Fed actions will offset some of the negativity caused by the U.S.-China trade dispute. We also expect an eventual easing of the trade dispute before the U.S. presidential election in November 2020. As a result, we have raised our Q4 2020 forecast for U.S. GDP growth to 1.5% from 0.7%, but the revised view shows up in a substantially stronger annual average growth rate in 2021.

While we expect slightly stronger growth in 2020 and 2021, it will remain subdued and below-trend well into 2021.

The US Economic Outlook: CBRE House View Q2 2019

FlashCall-06272019-F