Take It Easy: Inflation, Interest Rates and the Global Economy

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Spencer Levy
I'm Spencer Levy, and this is The Weekly Take. In a world of breaking news and fast moving trends around the world, we periodically hold invitation only conference calls with our teams, partners and clients. We call them Flash Calls. And on this episode, we got you a front row seat for our most recent.

Event Announcer
Welcome to the CBRE Flash Call.

Spencer Levy
It's an entrée to CBRE’s coverage of real world developments that may affect your decision making, top thought leaders addressing burning questions about current events. Held on May 10th, this Flash Call delved into inflation, the Fed's recent rate hike, impacts on capital markets and how they impact commercial real estate. It featured highlights and analyses by CBRE leaders from across the firm, including yours truly, along with key sector leaders, addressing questions submitted by our attendees. Coming up, Inflation, Interest Rates and the Global Economy – exclusive access to our latest Flash Call. That's right now, on The Weekly Take.

Spencer Levy
Welcome to The Weekly Take. We are pleased to be able to offer this special coverage to our listeners, a Flash Call, jam packed with informative takeaways during a time of market volatility. The presentations opened with big picture market insights, starting with a few words of context from Chris Ludeman, CBRE’s Global President of Capital Markets, to get things started.

Chris Ludeman
Inflation. War. A ten year treasury that has surpassed 3%. A 75 basis point rise in the Fed fund rates. A very steep SOFR Curve. Among others, these set the backdrop for today's Flash Call.

Spencer Levy
Chris provided an overview of the issues we were about to discuss, before handing off to Global Chief Economist Richard Barkham.

Chris Ludeman
There are concerns about rising cap rates. We've seen some evidence of that. There are concerns about the rising cost of capital and the availability of debt. We've seen that, too. Some sobering news for sure. But here's the good news. The commercial real estate markets are in pretty good shape. Fundamentals are darn good. Liquidity is deep. Transactional activity in the capital markets continues at a steady pace. Multifamilies surprised again to the upside of Q1, with double digit rent growth. The best core markets for industrial have zero vacancy. Glimpses of some slacking absorption by monster e-commerce players is giving other market participants a fighting chance to secure space. National absorption for office was well ahead of our Q1 forecast. In fact, large user occupier requirements in New York City are above pre-pandemic levels. Operational real estate in particular life sciences, hotels, student housing, self-storage, data centers, and single family rentals, to name a few, are performing well. But enough from me, now is the time to pass the baton to our experts. Richard, take it away.

Richard Barkham
So, thank you, Chris. I'm going to review the macro economic situation. 2021 saw a stunning rebound in US GDP growth and employment. And even though Q1 GDP growth was negative on weak exports, I think we all have a sense that the private sector in the United States has continued to expand at quite a clip, through Q1, into April and May. However, headwinds have developed over the last six months. I don't think they are overwhelming, but they are set to continue for a while. Those headwinds are: High oil prices, a weaker global economy due to the war in Europe, and to COVID policy in China. But most importantly, the upsurge in inflation, particularly in the United States, where it has hit 8.5%, a 40 year high. It's the United States that will determine the path of interest rates for the global economy.

Spencer Levy
Richard distilled the complex picture of interconnected events that the economy is dealing with right now. He analyzed the market forces and geopolitics – from the pandemic, to the war in Ukraine, effects on corporate earnings, and all the relevant dynamics – before summing up CBRE’s economic outlook for our insiders.

Richard Barkham
We think that the Fed funds rate will peak in 2023 at 2.5%, and growth will fall from around 3% this year to 2% next. We do believe that this term stagflation will take over from pandemic as the biggest concern, but it will be short lived. This is not the 1970s, and we believe that the economy will continue to provide reasonable support for commercial real estate fundamentals over the next 12 and 18 months. We may well see some yield correction, my colleagues will discuss that, but certainly no riot in the real estate sector. To me, the single family home market looks most vulnerable to a more serious correction right now. But even that isn't a foregone conclusion, particularly if levels of unemployment stay reasonably low. So that's our outlook for the remainder of 2022 and 2023.

Spencer Levy
After that comprehensive overview, our Global Head of Occupier Thought Leadership, Julie Whelan, took the mic to share expectations for office occupiers in the current environment. As many of you, especially our regular listeners may know, Julie just led the publication of CBRE’s 2022 Office Occupier Sentiment Surveys. She delved into the data, and opened with a 10,000-foot view of demand.

Julie Whelan
Getting employees to return to the office is extremely high on the agenda of many of the organizations today. We can safely say, finally, that a return to office is underway and picking up momentum after what has been a very long period of low visible occupancy in buildings. According to Castle Data, which many of us track as of the last weekly update, occupancies are at the highest level since the pandemic started. That's around 43% nationally, with Austin, Texas, actually being the highest occupied market at about 60% physical occupancy of buildings. Now, data from our recent 2022 Office Occupier Sentiment Survey suggests to us that this pattern is going to continue. Over 70% of our participants in that survey anticipate that a more normal return to office will continue to happen throughout 2022. So we don't think that any kind of economic uncertainty is going to throw this off course. Now, along with a return to office picking up momentum, we also know that office using employment is back above pre-pandemic levels. Now, when you look at the space that was returned to the market during the pandemic, it still hasn't been reabsorbed back into the market. So there's likely pent up demand simmering under the surface that should show growth.

Spencer Levy
Julie went even deeper into the numbers and market dynamics, taking Flash Call attendees inside the minds of occupiers across markets and industries.

Julie Whelan
Generally, we like to say that tenants are very cycle aware right now. Some may be driven to be very highly reactive and flexible, especially if they're in a volatile industry and in a volatile market. And there are others that may be driven to be more opportunistic, if they're a more stable industry that might be in a volatile market. So it's really difficult to make blanket assumptions right now across industry and markets at a time like this. But we know that the office market recovery is happening at a different place in various markets in the US. There are markets at different levels of recovery that might be defined by rents or vacancies or job growth or even tenants in the market looking for space. But pretty uniformly, even in markets that remain tenant friendly, we're seeing quite a flight to quality underway right now, and that's actually strengthening that end of the market. Tenants are really looking to welcome employees back to an office that has a better experience than the one they left. So, as we see new construction being delivered to the market, as tenants continue to flock to this quality space, we really do expect that there's going to be a further bifurcation in the market between the types of space offerings. Generally, we believe that the lowest quality buildings will likely be removed from inventory at a more rapid pace, as developers really look to convert them to their highest and best use in the market, which may no longer be office. So, as with any economic cycle, there are nuances across markets, across submarkets and individual buildings, and during uncertainty, especially a time like this, understanding market dynamics and tenant behavior trends is very important. But in summary, we would say that a market recovery is underway and will continue in this economic environment, even if progress becomes slightly slowed and skewed towards higher quality space in the near term.

Spencer Levy
Then it was my turn to offer perspective as a capital markets guy, to make sense of the relevant numbers and help clarify the impact of rising inflation and interest rates on commercial real estate.

Spencer Levy
What does all this mean for our average client? Well, different things for different asset types. Perhaps the most hard hit asset type in the short term is value add office, where we're seeing a significantly thinner number of bidders. And many of our developer clients have already increased their underwriting to add 200 basis points to their expected cost of debt over the next several years. Another observation in the debt capital markets is that alternative lenders have taken the top spot, maybe for the first time in my career, and many people are seeking multifamily, bridge, and construction financing.

Spencer Levy
After further discussion of financing and leasing, we talked about what it all means for investors.

Spencer Levy
Now, from an underwriting perspective, we're getting a couple of basic questions. One is, how do I underwrite my exit cap rates in an inflationary environment? And our answer is very straightforward. If you're planning on holding your asset three years or longer, don't raise your exit cap rate, more than you normally would. When you normally would raise it 50 to 100 bips, raise it by 50 to 100 bips, not more than that, because we think after two years from now, we think that inflation is going to be tame. In fact, it's going to be tame, probably starting in about a year from now. So don't change those exit cap rate assumptions because we think that the short end of the curve, while it may peak in around that two and a half percent level as Richard's suggested, we think it's going to rapidly fall back to about that one and a half percent level in 2024.

Spencer Levy
We went into a lot more detail on the call, of course, but the bottom line was that I echoed my colleagues in projecting enthusiasm tempered by the likelihood that we'll see choppiness in the market until we get greater certainty on inflation.

Rachel Vinson
Thank you, Spencer.

Spencer Levy
Then, after my presentation, Rachel Vinson took over to lead a Q&A. And we’ll now share some highlights to close our podcast, starting with a deeper dive into something Julie talked about earlier: a trend towards flight to quality.

Rachel Vinson
For this, I'll turn to Mike Watts, President of America's Investor Leasing. Mike, share with us your thoughts on this.

Mike Watts
Thanks, Rachel. I get asked this question a lot when I travel across the country. And one of the things to think about when you talk about flight to quality is, it is not just restricted to new construction. I think that's where people might be making a little bit of a mistake, and focusing a little too narrowly. Currently in the US, in the top 20 office markets, there is 460 million square feet of class-A office space in buildings that are 15 to 30 years old. These are the buildings and these are the owners that I talk to a lot and they're asking me, what kind of strategies should I have? If you think about it not as a flight to quality, but a flight to experience, because that's really what it is, yes, new construction affords a tenant and a developer a blank slate, but a flight to experience, an existing building can compete.

Spencer Levy
Mike reminded us that there are a lot of five star hotels in 100 year old buildings, giving us something to think about as Rachel then led the call into a round of relative quick hitters on sectors and asset types, each of which could be a podcast on its own. Will Pike, Vice Chairman and Managing Director of Net Lease Properties, brought us up to speed on that space.

Will Pike
Capital flows in demand have not waned at this point. It's more of a capital problem, not a capital demand problem or a capital markets problem. So I would say that for a demand standpoint, we're still at an all time high for investment. Put that into context. For the trailing 12 months, net lease investment volume increased by 49% to just over 95 billion. However, the sector is in a transition period, due to what has already been referenced on the call, year to date, a 150 basis point rise in the tenure.

Spencer Levy
Then Tom Traynor, Vice Chairman of Debt and Structured Finance, took a question on the cost and availability of debt.

Rachel Vinson
Tom, can you break this down for us by asset type, market structure and class? What are you seeing?

Tom Traynor
That is absolutely available. There's no question about it. This is not like the beginning of COVID where the markets were seized up. There's availability both on the fixed and floating rates side. In fact, there's a ton of liquidity in the space. That's across all lending types. You mentioned some of the lending types. Commercial banks are super focused on core clients. They have not gone anywhere. Life insurance companies, they have to match assets and liabilities. Absolutely still in business. Fannie Mae and Freddie Mac are busy in the multifamily market, as usual. What you're seeing in maybe a little bit of a slowdown, is in the debt fund space. Their cost of financing has increased.

Spencer Levy
Kelli Carhart, a Senior Managing Director and Head of Multifamily Debt Production, took a question about the overall fundamentals of multifamily. While the sector remains strong and continues to outperform, she pointed out that there's more to the record breaking numbers.

Kelli Carhart
However, as you've heard, the large increase, and expected continued increase, in the cost of debt capital, both fixed and floating, along with owners capitalizing on increased valuations and pursuing disposition strategies, is putting some downward pressure on valuations. So, will this put upward pressure on cap rates? The answer is likely yes, unless investors are willing to accept lower returns. The impact will vary by market and asset class. High growth markets will be least impacted by cap rate expansion.

Spencer Levy
Turning to another hot topic, Rachel raised an audience question about maybe the strongest asset type that's recently faced emerging challenges.

Rachel Vinson
What are the headwinds faced by the current environment, if any, for industrial, from supply chain due to e-commerce wavering? For this, I'd like to turn to Barbara Perrier, our Vice Chairman of Capital Markets, and one of our leaders of our National Industrial Partners team. Barb, your thoughts?

Barbara Perrier
Overall, the industrial world has been very favorable, and we've had a lot of good news coming out of it. The late slowdown right now of the e-commerce world, I think, is caused by, we're all returning to our lives as normal and we're not using the Internet and not ordering as much as we did back in the last two years.

Spencer Levy
That led to a question about retail. In our final excerpt, Rachel turning to Chris Decoufle, Executive Vice President and Managing Director of Retail Capital Markets in the Americas, to close out our call.

Rachel Vinson
Will 2022 be the year when retail regains its status as a major asset class? Chris?

Chris Decoufle
Interestingly enough, a lot of the trends that we've been dealing with for the last,almost decade, and then some of the new trends have all gone to retail strong suits. Number one, there's been no new construction for almost a decade, and by no new construction, nothing material. So you have a product class where you have population growth, you have wage growth, and you have expanding retailers and no new products. So that's number one. Number two, when we think about, you know, just the very nature of what retail delivers -- retail delivers current cash flow. That's what we're great at doing. And so in terms of interest rates going up, we still have a good cover between going in yields and total returns and total debt costs. And so when we look at our book across the country, we're seeing some reach rates for sure, but it's not as pronounced and it's not as knee jerk as you might see in some other product classes.

Spencer Levy
That wraps things up on our exclusive highlights from CBRE’s Flash Call. There was more to our conversation, of course, but we are pleased to bring even some of these informative insights to you at a time when we're all looking for answers. For more on inflation, interest rates in the global economy, and all that our Flash Call panel discussed, please visit our website, CBRE.com/TheWeeklyTake. The Weekly Take will return with our usual fare, as well as more surprises in the weeks to come. We'll take deep dives into retail, covering the sector from multiple angles. We will team up with CBRE’s Women's Network to help you sharpen your business tools with an informative episode on business networking and lots more that we are working on as we speak. For now, we thank you for joining us. We hope you'll share this episode, and also remember to subscribe to the show and review us wherever you listen. I'm Spencer Levy. Be smart. Be safe. Be well.