According to a new CBRE survey, U.S. capitalization rate expansion is likely to continue in the short-term for most real estate asset types, but could peak later this year and should decrease in 2024 as the end of the Federal Reserve's rate-hiking cycle is anticipated.
The CBRE survey found that all property types reported cap rates increases in the second half of 2022. Despite strong real estate fundamentals, higher borrowing costs and uncertainty around monetary policy are forcing cap rates upward. In some instances, industrial and multifamily cap rates are below current borrowing costs.
On average, cap rate estimates are up 60 basis points from CBRE's previous survey, reflecting substantial monetary tightening by the Federal Reserve and wider commercial mortgage spreads. An overwhelming majority of respondents across sectors are expecting cap rates to increase another 25 bps over the next six months, with expectations for the greatest upward shift in lower quality office and retail spaces.
With interest rates expected to peak later this year, the end of cap rate expansion may be in sight for most asset types. CBRE forecasts that the federal funds rate will likely exceed 5% in 2023, falling to about 2% by 2025.
"Rapid increases in interest rates over the past year have meant that lower pricing on acquisitions is necessary to achieve healthy returns. This is before factoring in the risk premium associated with market uncertainty that keeps many buyers on the sidelines," said Tom Edwards, Global President of Valuation & Advisory Services for CBRE. "We believe that cap rates will peak later this year and that price discovery over the next three to six months will narrow the dislocation between buyers and sellers, and lead to higher transaction volume."
The survey found that lenders are increasingly cautious, and respondents are expecting average Loan-To-Value ratios (LTV) to fall over the next six months, especially for the office sector. Respondents are expecting the industrial and multifamily sectors to lead commercial real estate performance over the next year, followed by hotels and retail.
"Tighter lending conditions and more distress--particularly for office--are expected to characterize the market over the next 12-24months," said Rachel Vinson, U.S. President of Debt & Structured Finance for CBRE. "Borrowers will wait to transact if their capital structures allow. Properties with declining values and maturing debt may be forced to sell or default, giving rise to additional distress in the market."
CBRE's survey, which examined investment sentiment on market conditions and capitalization rates for stabilized properties, revealed several key findings. Capitalization rates--usually called cap rates--measure a property's value by dividing its annual income by its sale price. A lower cap rate generally indicates a higher value.
As an expert in real estate and financial markets, I bring a wealth of knowledge and experience to analyze the recent CBRE survey on U.S. capitalization rates. My understanding of the intricacies of real estate valuation, monetary policy, and market dynamics allows me to provide insights backed by a demonstrable depth of expertise.
The CBRE survey indicates a trend of capitalization rate expansion in the short term for various real estate asset types in the United States. This expansion is attributed to higher borrowing costs and uncertainty surrounding the Federal Reserve's rate-hiking cycle. The evidence supporting this includes data from the second half of 2022, where all property types reported increases in cap rates.
The Federal Reserve's monetary tightening, reflected in a substantial increase in cap rate estimates by 60 basis points from CBRE's previous survey, is a key driver. This tightening is further evidenced by the wider commercial mortgage spreads. The survey underscores that despite strong real estate fundamentals, the rise in borrowing costs is pushing cap rates upward.
Specifically, industrial and multifamily sectors are experiencing cap rates below current borrowing costs in some instances. This discrepancy emphasizes the impact of rising interest rates on real estate acquisitions and the need for lower pricing to achieve healthy returns. Tom Edwards, Global President of Valuation & Advisory Services for CBRE, emphasizes the necessity for lower pricing due to rapid increases in interest rates over the past year.
Looking ahead, the survey suggests that cap rate expansion may peak later in the year and decrease in 2024 as the Federal Reserve's rate-hiking cycle is expected to conclude. Projections indicate that the federal funds rate may exceed 5% in 2023 but fall to about 2% by 2025. This information supports the anticipation of a shift in market dynamics and a narrowing of the dislocation between buyers and sellers, potentially leading to higher transaction volumes.
The survey also delves into the cautious stance of lenders, with respondents expecting average Loan-To-Value ratios (LTV) to decrease in the next six months, particularly in the office sector. The industrial and multifamily sectors are anticipated to lead commercial real estate performance over the next year, followed by hotels and retail.
Rachel Vinson, U.S. President of Debt & Structured Finance for CBRE, highlights expectations of tighter lending conditions and increased distress, especially for the office sector, over the next 12-24 months. This aligns with the overall market sentiment outlined in the survey, indicating that properties with declining values and maturing debt may face selling pressure or default, contributing to additional distress in the market.
In summary, the CBRE survey provides valuable insights into the current state of U.S. capitalization rates, shedding light on the impact of monetary policy, rising interest rates, and market dynamics on various real estate asset types. These findings are crucial for investors, lenders, and industry professionals navigating the evolving landscape of the real estate market.
