Are We Out of the Woods Yet?

There’s a lot to absorb in the current market environment. 

Coming out of their June meeting, the Federal Reserve temporarily paused interest rate hikes for the first time since they first started dialing them up in March 2022. However, the Fed anticipates up to two additional rate hikes, which, if they follow through on, could jump the benchmark Federal Funds rate up to as high as 5.75% before the end of 2023. Is one rate pause enough to begin shifting the market's perception?

Too much information combined with rapidly shifting market dynamics can send people into a state of analysis paralysis. For the CRE market, much of today’s paralysis is centered around the current and perceived future state of interest rates and, correspondingly, the state of the capital markets. 

Although the current perception of the overall health of the CRE market is still relatively weak, I believe we sit at an interesting point in the market cycle with select opportunities that generally do not present themselves during growth periods of the cycle. From my vantage point, operators and developers are increasingly adopting realistic perspectives for capitalizing their projects, both in terms of pricing and how they structure them. There is a trend of urgency that I see emerging to embrace the new reality instead of trying to justify why a deal that previously made sense (before the rate hikes), might still make sense in today’s high interest rate environment. This shift is significant because deals that make sense in the current environment of high interest rates may experience tailwinds in the future if and when interest rates decline. Before I expand upon my thoughts on further interest rate changes, it’s helpful to consider the following aspects of the current market to set the stage:

While we don’t know if we are at the bottom of the market (and we don’t generally know the actual bottom of the market until months after it has occurred), the dynamics I discussed above suggest to me that we may currently reside somewhere near the trough of the cycle.

Once we actually reach the bottom of the market, a logical question to ask would be, “When do we begin to see growth in the market again?” While there likely will not be a single catalyst event that will pivot us into a growth phase of the cycle, the one thing I keep observing is that market participants are eagerly waiting to see the first interest rate reduction from the Fed. Once the Fed issues its first rate reduction, I would expect that it would provide an “all clear” signal for capital to resume flowing into the market at a greater scale.

When might Powell begin to lower interest rates? Here’s what history says.

Historical data suggests that following a tightening cycle, the Fed typically enters into an easing cycle when we either 1) get confirmation of a recession or 2) there is sufficient inflation-cooling data in the market showing that the rate hikes have done their job. 

According to the Fed's data which is shared in the chart below, since 1955, nearly every cycle of monetary easing following a cycle of monetary tightening has kicked off during a recession. To me, this suggests that the Fed’s playbook reads: To cool down the economy, we must tighten monetary policy until we hit a recession; then we can ease.

Figure 7: Federal Funds Effective Rate by Year (with recessions highlighted)

Note: Shaded area represents recession, as determined by the National Bureau of Economic Research. Source: Federal Funds Effective Rate, FRED Economic Data, June, 2023. This chart is for illustrative purposes only.

If a recession does play out as many still expect later this year, it may be logical for the Fed to revert to a rate easing cycle at some point in 2024 once they receive confirmation that we have entered a recession.

However, as we progress through the year, I believe that the odds of a recession appear to be diminishing instead of increasing due to a few factors. For one, the job market remains stubbornly resilient as it continues to add jobs, soundly beating expectations yet again in May. Then on June 8th, 2023, Goldman Sachs reduced its expected probability of the US entering into a recession from its earlier reading of 35% down to 25% citing,  “a recovery in real disposable income and the stabilization in the housing market leaving us with a 2023 growth forecast of 1.8% (annual average), well above both the private-sector consensus and the Fed’s view.”

So what could happen if we don’t enter into a recession? Will the Fed keep raising interest rates?

While the Fed has telegraphed up to two additional rate hikes later this year,  I believe we may be getting closer to the peak of the tightening cycle.  Here’s why.

1. There is quantifiable good news in the form of leading data, particularly housing costs data, to suggest that the Consumer Price Index (“CPI”) disinflation we’ve been experiencing over the last 10 successive months will continue in the months ahead.
   
   

   Housing costs which account for roughly about one-third of CPI, have a notable lag between when actual rents at the street level translate into the data that show up in the monthly CPI calculation. While it’s somewhat debatable how long that lag actually is, Jay Parsons, a housing economist at Real Page, argues that it is roughly 12 months. In one of Jay’s recent LinkedIn posts, he outlined how rent inflation peaked in March of 2022 and that, accordingly, the housing component of CPI (“Rent of Primary Residence”) seems to have peaked in March of 2023.

   If Jay’s prediction is correct, we should see declines in rental rate growth (that we saw throughout 2022) continue to show up in CPI data throughout the remainder of this year. Considering that we have seen residential rent growth start to flatline in early 2023 based on CoStar and RealPage data, we could see CPI decline even further in early 2024, perhaps to levels that steer the overall inflation number to the Fed’s long-term goal.^1,3

      Figure 8: CPI Rent Cools For Second Straight Month With Sharper Cooling To Come

   

   Source: RealPage Market Analytics; Federal Reserve Economic Data (FRED) & BLS, June 2023. This chart is for illustrative purposes only.

2. The second reason why I believe interest rates may peak soon lies in the economic concept which argues that to quell inflation, you must raise interest rates to a level that is above the inflation rate. The theory goes that once the cost of borrowing exceeds the inflation rate, it compels consumers to change their spending behavior which can lead to disinflation. The execution of this strategy in 1981 is what made former Fed Chair Paul Volcker famous when he increased the Fed Funds rate to 19% to smash inflation that reached nearly 14% in 1980. What’s interesting is that the Fed Funds rate (currently at 5 - 5.25%) is now 100+ basis points above CPI (4.0% as of June data) and the expectation is that this spread between the federal funds rate and the rate of inflation will widen over the coming months. Look at how fast inflation is already falling this year - see Figure 9

Figure 9: Inflation is coming down steeply

Source: U.S. Bureau of Labor Statistics, June 2023. This chart is for illustrative purposes only.

If this theory holds true, inflation should continue to fall. And if inflation continues to decline anywhere near its current rate then it is plausible that the Fed will maintain a pausing stance regardless of whether or not we enter into a recession. It makes you wonder, does the Fed really need to accelerate the rate of disinflation beyond where it is right now?

It’s interesting to see what the market believes and, particularly, what the Fed itself believes interest rates should look like in the next few years.

The chart below, provided by Chatham Financial, depicts two forward-looking interest rate scenarios, 1) the line graph depicting Chatham financial’s 1-month Secured Overnight Financing Rate (“SOFR”)⁶ projections at each point in time; you can assume that’s the “market” and 2) The series of dot plots,  which show the midpoints of where each Federal Open Market Committee (“FOMC”) member indicates their target federal funds rate. In both cases, the market and the Fed believe that lower future interest rates are in store over the next few years. Given how transparent the Fed’s guidance has been thus far, it seems plausible that we may land at the FOMC midpoint for the next two years. Therefore, I think we need to exercise patience in the rate of future interest rate reductions as there is probability of some relief beginning next year.

6. The Secured Overnight Financing Rate (SOFR) is a key benchmark that variable or floating rate loans are priced off of. SOFR is a fully-transaction-based, nearly risk-free reference rate. It is a broad measure of the cost of borrowing cash overnight collateralized by U.S. Treasury securities. Our Investment team regularly utilizes this rate as a benchmark to analyze deals. Typically, the higher rate, the higher the cost of debt that is underwritten into deals. Read more here.

Figure 10: Chatham Financial's forward curve and the Fed's Median Plot

Source: Term SOFR, USD LIBOR, and Treasury Forward Curves, Chatham Financial, June 2023. This chart is for illustrative purposes only.

Now for the burning question..

Are we out of the woods yet?

Barring the office sector from this question, I believe we have reached a point in the market where the conditions for identifying mispriced investment opportunities may be coming to a close. There may still be additional downside ahead but we seem to have enough pessimism priced into deals where you can realistically believe in the prospects of some potential upside. Therefore, I’m inclined to believe that today’s pricing and terms, on average, may have a probability to be favorable in comparison to those offered by next year’s market.  No one can accurately predict how soon the window of trough investing may close and it doesn’t mean that today’s deals may necessarily be more viable than tomorrow’s deals. But I do feel that we’ve reached a tipping point.

Investing in real estate is typically measured in years and not months. Ultimately, the litmus test I’m looking for includes scenarios where I can bake in a series of rational assumptions, considering all known information, and then have confidence that I’m not materially underestimating the probability of unknown factors which could topple the entire business plan. 

Provided that those series of assumptions factor in a reasonable margin of safety for the next 12 to 24 months, I am embracing a greater overall level of confidence that better days may be just ahead. If the market gains a similar consensus, I then believe we may enter a new phase where market participants begin to separate some of the paralysis from the analysis. At that point, the trough of the market could be in our rearview mirror.

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