Puppy Dogs, Rainbows and Three Caps

A nation’s overall happiness is not necessarily based on the strength of its economy.

Take Japan, for example. Its economy hasn’t grown much in almost 30 years, but it has one of the highest standards of living in the world and, according to a recent study by the CATO Institute, is the third “least miserable” country on earth. The U.S. is the 28th least miserable out of 95 countries ranked by CATO, which derives the rankings by the sum of each nation’s unemployment, inflation and bank lending rates minus the percentage change in real GDP per capita.

As I turn 50 this year, I’ve begun to think a lot more about things money can’t buy: more time with my kids, a decent first baseman on the Baltimore Orioles and the pursuit of happiness. I also wonder what’s happiness worth? While happiness is great, it may be a bit overrated. Based on seven independent studies, happiness peaks at the ages of 16 to 18 and 86 to 88. Everyone else—and this means you—is pretty much at the nadir of miserable for most of their lives.    

So, what is happiness worth? The eternal sunshine of the spotless mind, ignorance is bliss and happiness is a warm gun (thank you John Lennon) all sound pretty good to me and sound even better as I get closer to my 86-year-old fountain of new happiness! And if happiness is measured by cheap stuff (i.e., a $500, 68-inch smart TV) and more free time, then 2019 is a good year. Technology and innovation have made all stuff cheaper (though services costs have skyrocketed) and many big employers are experimenting with four- and even three-day work weeks as knowledge-worker productivity has increased.

The problem is that the same forces that are increasing our happiness—particularly innovation that, due to efficiencies in things like electric cars, makes us use less stuff—are also slowing economic growth. These four forces are too much cheap money, cheap labor, cheap energy and innovation itself. So we may be happier, but we are in for slow growth, low inflation and low interest rates for a long time. Big deal you say, at least we are happy! Well, I like puppy dogs and rainbows as much as the next guy, but I can’t put them in my 401(k), which requires growth and cold hard cash.

The silver lining to lousy growth is lower cap rates for commercial real estate. In short, because growth has slowed globally, we are in a seemingly permanent environment of lower interest rates and inflation. This lowered cost of debt capital, combined with the increasingly lower cost of equity capital as both international investors and large U.S. domestic institutions increase their allocations to U.S. commercial real estate, means that cap rates can and likely will get lower. U.S. growth may be slowing, but the country’s relatively high-yielding (compared to bonds) commercial real estate is the cleanest dirty shirt in the global investment laundry.

“I can’t believe I’m paying a four cap.” Just wait. European inflation is falling, and the U.S. is following suit. EU cap rates are typically 50 to 100 basis points lower than U.S. cap rates for comparable assets because of lower inflation. Lower inflation ahead means lower cap rates are the latest luxury European export that will line the pockets of U.S. commercial real estate investors in the form of declining cap rates across the board in core markets like New York, Los Angeles, San Francisco and Washington, D.C.   Don’t be surprised when the three cap becomes the new four cap in the U.S.

Jamie Dimon, Alan Greenspan and a lot of other smart folks believe that the 10-year Treasury rate could go to zero to match the $17 trillion of zero or negative interest rate bonds globally. This means commercial real estate investors investors will do well in the years to come. With slower growth, my 401 (k) may be a disappointment in my golden years, but at least I’ll be happy (particularly if I buy a puppy)!

By Spencer Levy, Chairman, Americas Research & Senior Economic Advisor, CBRE.

Fed Sticks to the Script

In a widely expected move, the Federal Reserve raised its interest rate target by 25 basis points on Wednesday. The Federal Open Market Committee (FOMC) voted unanimously in favor of the increase, which raises the target range for the federal funds rate to 0.50%-0.75%. This is the first policy change since the FOMC increased rates for the first time in eight years in December 2015.

All signs pointed to a rate hike, including strong signals from Janet Yellen and other Fed officials. The economy has continued to move closer to the FOMC’s objectives of full employment and stable 2% inflation in recent months, leading Fed officials to publicly suggest that a rate hike would be warranted. Investors were convinced as well, with futures markets indicating a 95% probability of an increase ahead of the two-day meeting.

The election of Donald Trump as the next U.S. president, combined with Republican control of Congress, has caused many economists to revise their near-term growth projections upward. The Fed has not materially changed its economic outlook, though the new projections reveal a slightly more optimistic view of GDP growth and unemployment in the next few years. Their interest rate outlook also changed slightly; the FOMC members now expect three interest rate increases in 2017, up from two as of September’s meeting. The absence of a significantly changed outlook affirms the Fed’s commitment to “data dependence” and aversion to speculating on the Trump administration’s policies. Fed Chair Yellen is a proponent of expansionary fiscal policy, which would ease the reliance on monetary policy to spur growth.

The public markets have reacted favorably to the election as evidenced by the series of record closes in the stock market and the rapid expansion of yields in the bond market. Treasury yields are up more than 60 basis points since Election Day. This increase in bond yields could give the Fed cause to take short-term rates higher down the road, as it will be less concerned about inverting the yield curve. Importantly, this would provide needed room to lower rates if and when the next recession hits.

Because of this recent run-up in long-term interest rates and the certainty with which markets priced in the Fed’s December move, we expect limited reaction in capital markets to this 25 bps increase. While commercial real estate capital values typically are sensitive to higher rates, most transactions are going under contract or closing at originally agreed upon terms, though some transactions have re-traded, particularly in highly leveraged transactions. The debt markets have shown somewhat more movement, including higher loan costs, lower LTVs, delayed refinancing and some buyers moving down the yield curve to lower all-in rates.

These sales and debt capital market movements are early indicators rather than trends. U.S. CRE fundamentals remain healthy and investment into the sector continues to be strong. Rising interest rates don’t necessarily lead to rising cap rates, especially in the short term. Given that the U.S. remains a magnet for global capital, cross-border capital flows could offset some domestic softening in cap rates.

By Spencer Levy, Head of Research, Americas, CBRE.

Cracks in the Wall?

Over the past two months, it has become increasingly apparent that maturing CMBS loans are having difficulty in paying off in a timely manner, which has resulted in an uptick in delinquencies. There appears to be two culprits for the declining performance.

The disruption in CMBS lending that took place in the first half of 2016 had a negative impact on the overall capacity of the market to absorb a growing pipeline loan refinancings, causing some deals to slip past their scheduled maturity dates. In addition, the credit quality of maturing CMBS loans has been on the decline, reflecting the effects of extremely aggressive underwriting prior to the financial crisis and a persistent weakness in loan credit measures.

As we move forward through the remainder of 2016 and into 2017, we believe that there are both positive and negative sides to the CMBS maturity story. On one hand, liquidity has been restored to CMBS market, as tightening spreads have allowed lenders to offer competitive quotes.  However, there is the constant backdrop of concerns that prospects of an impending interest rate hike by the Federal Reserve could set off another round of market volatility. In addition, risk retention measures, which go into effect in December, could increase loan pricing.  A greater concern, however, is that the credit issues on maturing CMBS loans are likely to remain challenging, especially as we move into 2017.

Recent statistics show that the H1 2016 slowdown in CMBS lending activity has adversely affected CMBS loan payoff rates. According to Morningstar, the initial payoff rate for maturing CMBS loans in July was only 62.7%, down from 68.0% in June. The slip in initial payoff rates is significant, since in recent months rates had held up fairly well. Through most of 2015 and early 2016, initial loan payoff rates exceeded 80%.

In addition, payoff rates have been even higher when looking back three months post-maturity. On this basis, pay-off rates have exceeded 90% quite consistently. However, by April it appeared that the market had shifted, with the three month post-maturity payoff rate slipping under 90%. Recent figures indicate that the payoff performance of office and retail loans–which comprise the majority of the maturing loan pipeline–have been the most negatively affected, while multifamily loan payoff rates have been slightly better, according to Morningstar.


The recent uptick in CMBS loans that have matured and are currently delinquent on their monthly payments is reflected in the Morningstar’s overall delinquency statistics. In July, the volume of loans that were either 30 or 60 days past due reached $4.89 billion, up from $3.38 billion in April.

Is the slowdown in the CMBS origination market earlier this year to blame for the recent decline in payoff rates and the CMBS refinance market? The lack of liquidity in the CMBS market has clearly played a role in explaining the decline in payoff rates. This is not the only factor that can explain the trend in payoff rates. Banks, life companies and other lenders, such as private debt funds have been quite active in providing financing throughout the eight months of the year. Indeed, most of the largest CMBS loans that matured in H1 2016 were refinanced by bank syndicates, life companies, and the agencies. Rather, the declining credit quality of maturing CMBS loans appears to be accounting for a substantial share of refinancing difficulties.

As we noted in our study “Scaling the Wall: The Outlook for Commercial Loan Maturities” released earlier this year, there was a clear deterioration in loan quality as we approached 2007 vintage loans. Based on our estimates, we found that 18% and 27%, of the 2016 and 2017 loan balances, respectively, would likely face some difficulty in refinancing at maturity.  We based this analysis on the loan-by-loan debt yield distribution, where we identified those loans with a debt yield of less than 8% as “at risk”.

As we examined the credit profile of maturing loans in the Morningstar database, there appeared a steady trend of deteriorating credit measures as we moved along in time toward late 2006 and 2007 vintage originations.

Morningstar’s recent report also highlights the declining credit quality of impending loan maturities. According to their valuation analysis of loans scheduled to mature over the remainder of 2016, they note that 46% have an LTV of 80% or greater, a level that is correlated with a reduced on-time pay-off rate. This would suggest an overall 2016 payoff rate of around 70%, after taking into account previous 2016 maturing loans that have already paid off successfully.

Through August, overall CMBS issuance activity is just over $41 billion, far short of the $70.8 billion issued over the same period in 2015. While CMBS issuers have re-entered the market over the last two months with increasingly competitive deal quotes, the market is playing “catch-up” with the large volume of matured loans in need of refinancing and restructuring. While refinance conditions are much more favorable now than they were a few months ago, there are some concerns market volatility could re-emerge, especially as the Federal Reserve contemplates interest rate hikes in the coming months.

In addition, the CMBS market is being re-shaped by regulatory issues, especially new “risk-retention” rules that go into effect in December.  Many market participants believe that these regulations will ultimately reduce capital availability and raise CMBS loan pricing. However, there has been an increase in private lenders and debt funds that are poised to take advantage of the refinance opportunities. These lenders could continue to fill part of the gap left by CMBS lenders.

The market bears will be watching closely over the next few months.  If pricing remains stable and CMBS issuers are able to raise enough capital to satisfy risk retention rules, then capital availability may remain in relatively good shape.  However, the credit quality is likely to remain challenging, resulting in a high level of deferred payoffs and restructurings of maturing CMBS loans.

By Mark Gallagher, Senior Strategist, Americas Research – Investment Consulting, CBRE.



Hitting the Rewind Button Is Impossible on an 8-Track

Probably the most ‘1970s’ thing that I can remember is the 8-track tape. For those of you who think that even CDs are ancient technology, the 8-track tape was a magical device. By hitting a button on the player, you could skip to another song (“track”) at a random place in that song as all the tracks ran simultaneously. You never knew exactly where you were going to land and, unlike its “cassette” cousins, you cannot rewind an 8-track tape.

Hitting buttons on an 8-track tape player is probably the best way to describe what the Fed is going through right now. They know that the songs and have a lot of buttons to push, but they don’t know exactly where they are going to land when they do. Just when the Fed thinks the next button they push on ‘Solid Gold Hits From The 70s’ is going to pull up “You Light up My Life” by Debbie Boone, Meatloaf’s “Two out of Three Ain’t Bad,” seems to randomly spill from the 8-track deck of a 1978 Maroon Pontiac Bonneville Brougham. I don’t envy Janet Yellen and team this week.

Two positive jobs reports, low unemployment, increasing core inflation (excluding energy), an improving stock market and a strong Thanksgiving holiday sales week put us on cruise control to a 25 bps rise by the Fed on Wednesday. That is until last Friday (Dec. 11) when the bond market had different ideas.

As I stated in my piece “Hitting the Rewind Button” from early November, the bond market is still the most powerful force in the Universe. On Friday, the 10-year T dropped 10 bps to 2.14, the S&P 500 fell to negative territory for the year and the VIX (“fear”) index went through the roof (up over 25% in one day). There were several reasons for this led by the continued plunge in oil and other commodity prices, but the proximate cause was the blow-out in spreads on junk bonds and the 10-year T as well as a major high-yield bond mutual fund closing temporarily halting redemptions. A lot of the junk bonds are held by companies in the oil and gas business, but the contagion spread to other low-rated company bonds as there are growing fears of a more wide-spread slowdown.

I am sticking with my prediction in “Hitting the Rewind Button” that the Fed will raise the Fed Funds rate by 25 bps on Wednesday. The Fed is likely to cite the October and November jobs reports, especially the appearance of the other “i” word, inflation, in the form of year-over-year wage increases at their strongest levels since 2009.

There is also increasing concern from the Fed about the “b” word in commercial real estate and leveraged M&A loans [see Saturday’s WSJ for a detailed discussion of these Fed fears] and they have real incentive to tap the brakes looking beyond the events of the past few days.

That said, if we see the 10-yr T dip below 2% and the stock market drop sharply on Monday-Wednesday (a risk after Friday’s sell off), I am switching my vote to “hold.” In other words, while I am standing by my predictions from a few weeks ago, I didn’t realize that the Fed was playing an 8-track tape that can’t rewind, so the outlook is less certain today.

By Spencer Levy, Americas Head of Research, CBRE.


Hitting the Rewind Button

I have changed my mind. I now believe the Fed is going to raise interest rates in December.

This updates my opinion stated two weeks ago at our Americas Summit in Denver.  It is also consistent with our global ‘house view’ that expects a slowly rising interest rate environment.

During September, I was the most optimistic guy in the room for the first time in my career.  At that time, the U.S. stock market had its first correction (10% move down) in almost four years largely due to heightened concerns about China.

All three pillars of our economy — the Consumer, Business and the Government (notably, the Fed) — were suffering from the 401(k) effect or, as Ben Bernanke put it in his book, the “201(k) effect.”  Watching the value of your retirement account decline has no “real” effect on most people, but has a major impact on sentiment.

Why did I change my mind? The most important things I look at every day, other than the faces of my wife and children, are the 10-Year Treasury and the performance of the U.S. stock market. They sum up everything that is going on in the economy in a simple, clear and understandable manner.

In the words of James Carville, the former campaign strategist to President Clinton, when asked if he could be anyone — the Pope, the President of U.S., a .400 hitter — he answered “the bond market.”  While I do not agree with Mr. Carville about everything, I agree that the bond market may be the most powerful force in the universe.

Here are the numbers. The 10-Yr Treasury hit 2.33% on Friday, up from 2.02% on October 27 (the day before the Summit).   This is a massive move and is the highest level since July 21 (right before the China “hard landing” concerns spooked the U.S. market).  I do not believe it is a coincidence that the S&P 500 closed on Tuesday at 2,109, its highest close since July 22.

In summary, we hit the “rewind” button and we are precisely back to where we were before everyone caught China fears.  While focusing on bond yields and the stock market – as opposed to traditional indicators (the usual suspects) — may seem like a bit of “Economic Phrenology,” or someone who confuses cause and effect, I believe they are essential bellwethers because of how widely they are followed and how broadly they affect sentiment.

Consumer, Business and Fed sentiment are everything.

By Spencer Levy, Head of Research, Americas, CBRE.