Here’s Where Core CRE Cap Rates Will Settle, Expert Says

High inflation ended the era of easy money, and now many commercial real estate investors are facing hard times. To gain some perspective, LoopNet spoke with Nick Axford, chief economist at Avison Young, based in London.

Below are excerpts from that conversation, that provide his outlook about stubbornly high inflation, and how it will affect interest rates and core real estate asset capitalization rates over the next 12 months.

He indicated that at this point, based on available data, it appears policy rates will settle in the latter part of 2023 or in early 2024. That would remove some uncertainty from the market, and barring unforeseen circumstances, it appears cap rates will settle between 5.5% and 5.75% and potentially come down a bit afterward.

Rates are currently in flux and it's essentially unknown when central banks will stop raising rates. You wrote in an outlook piece that you're anticipating rates will settle in the middle of 2023. Is this still the case?

Now we've gotten to the point where most of the central banks, certainly in North America, are kind of pausing, unless something unexpected happens. They are pausing because we know it takes time for the effects of the higher rates to feed through [the economy]. The Federal Reserve is still warning that rates could go higher and I think that we're probably expecting another 25 to 50 basis point increase in rates in the United States. The economic and employment news we've been getting has been stronger than expected, and probably stronger than the Fed would like to see right now. So, the current noise is that the Fed may have to push up just a bit higher to 5.25%.

But what has happened is that the tone of the discussion has changed, and [market watchers] are no longer asking if the Fed will go to 6.0% or 7.0%. We're at a point where some of the spreads, swap rates and expectations about government bond yields have all started to come back down because the uncertainty premium [about how high rates will go] is coming out. This scenario has market participants thinking that we are probably in the territory we are going to be in for the next 12 months or so.

And there's talk that possibly at the end of this year — though I'm not so sure — or early next year, we might see the Fed start to pull interest rates back again. So, there's a different tone to the full view today than there was even four months ago, let alone six months ago.

One expectation was that policy rates would rise and plateau. Discuss why they might be pulled back.

So, in thinking about where interest rates will go, the expectation is that inflation is now coming down and that a lot of the problems that were driving inflation — like supply chain disruption and elevated energy prices related to Ukraine, along with other sorts of things — are all going away. But, given that the economy isn't particularly strong, the Fed is concerned that weakness may return to the economy in the coming year as interest rate increases take effect [potentially causing business and personal spending to contract].

The key thing from our point of view is, firstly, we think that inflation might prove stickier. This is particularly true given current labor market conditions [characterized by low unemployment], that could make employment a bit stickier. With this scenario, the Fed is going to be reluctant to bring rates down at all, until it’s convinced that inflation is heading well back toward its target area of 2%.

And I think that's going to be, at best, in the final part of this year and quite possibly into next year. The second key thing, returning to real estate, is they're not trying to get interest rates back to zero. They're probably trying to get them back into the 2% to 3% range, which is kind of where they were headed in 2019 before the pandemic.

After interest rates settle, where do you think cap rates will be for core office and multifamily properties? Will they be where they were six or nine months ago, or will they settle at a higher level?

They're certainly going to settle at a higher level. I can't guarantee this is up to date right now because I haven't looked at these recently, but for office, at least as far as the data that we've got, cap rates haven't moved materially.

If we think that the risk-free rate is going to get to 3.0% or 3.25%, and if we assume that the spread [between ten year government bonds and BBB corporate bonds] is going to be around 200 basis points, which is what it has been rather consistently, then that takes you to 5.25%.

So, if you then add on 50 basis points of real estate premium, which at the prime end is not inconsistent with what we were seeing previously, then that gets you to somewhere around 5.5% to 5.75%, which is our thinking about the probable equilibrium going forward.

Do current interest rate hikes represent the return to normalized rates that real estate professionals have been anticipating for 15 years?

Yes, they do. Broadly speaking, in 1999 and into 2000, rates were pushed up to constrain what was seen as growth from “irrational exuberance” during the technology boom. Then we saw a period [roughly between 2001 and 2004] where rates were cut because of the recession that followed the collapse of the tech boom. During this time, interest rates were cut quite sharply to try and stimulate the economy.

We then had the period [roughly between 2004 and 2007] in the run-up to the financial crisis where interest rates were progressively being raised to constrain the growth that was occurring at that time. The financial crisis began in 2008 and that was the point when everything changed. There was a coordinated and very quick decline in interest rates, down to about half a percentage point, which was far lower than we had seen in any previous period. And then we saw the period after the financial crisis [roughly 2009 to 2017] where, broadly speaking, interest rates were very low and very stable. In Europe, we saw interest rates go negative.

In the U.S., what we saw between 2017 and 2019 before the onset of the pandemic was that interest rates ratcheted up incrementally, particularly in North America because the economy was moving ahead. That was when the Fed was trying to normalize interest rates to get away from these ultra-low rates that we saw during the second decade of the century. This was done because if interest rates are that low, central banks cannot cut rates to stimulate the economy if it contracts, which is what they ended up doing after the pandemic struck.

Central banks were aware — the Fed in particular, but also to some extent the Bank of England — that these low levels of interest rates, coupled with quantitative easing [or the purchase of government bonds by central banks] were feeding money into the global economy.

It was unclear where all that money was going and how it was flowing through [the economy], but there were concerns about the potential for it to cause [investment] bubbles [or periods when current asset prices exceed their intrinsic values] and real estate was being highlighted in that period as a particular area of concern. This was because as the economy was expanding and people were searching for higher yields in their investments, their money was going into real estate.

Then the pandemic occurred, and [from about 2020 to mid-2022] we went back to very low-interest rate levels to support what was expected to be a very difficult time for the economy, which it was with record levels of GDP contraction. And then supply chains delayed in recovering as economies picked up and that's what drove the very strong uptick in inflation.

This interview has been edited for brevity and clarity.