Will Rising Interest Rates Put Upward Pressure on Cap Rates?

Interest Rates and Cap Rates Not Directly Correlated

• Some investors think sellers must raise cap rates when interest rates increase in order to draw in enough buyers
• This has not held up historically, spread between interest and cap rates have varied significantly
• Yields can vary greatly by property type and market

Many Factors Currently Impacting CRE Yields

• Elevated liquidity forcing investors to compete for assets, willing to accept lower yields to invest capital
• Stock market volatility likely to drive investors to stability of CRE, putting downward pressure on cap rates
• Property types and markets with momentum or value-add opportunity draw new interest, keeping cap rates steady

Investors Need to Consider Future CRE Trends

• Demographics to reshape CRE; Retiring Baby Boomers and aging Millennials will drive certain property types
• Paying a premium now could provide opportunity for elevated returns over next few years
• Upward cap rate momentum in some markets and property types expected, unlikely to be broad-based

*Through May 11
Includes apartment, retail, office, and industrial sales $1 million and greater
Sources: Marcus & Millichap Research Services, CoStar Group, Inc., Real Capital Analytics, Federal Reserve

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What the Largest Rate Hike in 20 Years Means for CRE Investors

Fed Taking Aggressive Action to Combat Inflation

• CPI inflation reached highest level in 40 years
• Fed hiked the overnight rate by 50 bps and announced plans to shrink its balance sheet at last week’s meeting
• Goal of making money more expensive to borrow and slow spending, curtailing demand-side price pressure

Are These Decisions Too Little, Too Late?

• Many of the underlying inflation drivers, like supply chain disruptions and shortages, have not been addressed
• Elevated household cash savings could limit initial impact of Fed actions
• More rate hikes expected if inflation does not slow

CRE Investors Should Position Themselves Advantageously

• Inflation likely to persist, property types like Apartments, Self-Storage, and Hotels can help mitigate impact
• Plan for rising interest rates – Lock in longer-term debt as soon as possible
• Strong household balance sheets remain a tailwind for spending, supports outlook for various property types

*Through May 04
Sources: Marcus & Millichap Research Services, Federal Reserve

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Why CRE Buyers aren’t Moving to the Sidelines

Look Beyond the Headlines and Focus on the Facts

• Economic fundamentals are solid; 1.7M jobs were created in 1Q22, pushing unemployment down to 3.6%
• An additional $6T more cash on hand than normal is helping drive record retail sales
• Households have more cash savings than debt for the first time in 30 years, a strong positive for the economy

Investors Have Wide Range of Options Within CRE

• Investors can choose between different property types, asset classes and markets that best align with their goals
• Opportunities exist in top-tier premium assets in sought-after markets all the way to value-add in softer markets
• Depending on the composition, cap rates can range from mid-2% all the way to as high as 9%

Real Estate Investors Are Planning for the Long-Term

• Unlike with more volatile investments, CRE investors do not trade sporadically, only when circumstances change
• CRE delivers long-term cash flow and inflation resistance
• Commercial real estate is particularly suited for the current economic climate and the road ahead

*Sources: Marcus & Millichap Research Services, Federal Reserve

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Retail Sector provides Opportunities for CRE Investors

Retail Sector Recovery Well Underway

• March core retail sales exceeded $468B; up 6.2% from last year and 24% from pre-pandemic
• Even when adjusted for inflation, sales are up 1.1% Y-O-Y and 16% from pre-pandemic
• Although retail job loss was significant, there are already 278K more retail workers than before the pandemic

Retail Performance Stronger than Many Believe

• Despite the ongoing recovery, just 20% of investors said it’s a good time to buy Retail, compared to 19% for Office
• Office vacancies are still over 300 bps higher than before the pandemic while Retail vacancy is only up 40 bps
• Retail foot traffic and rents are higher than pre-pandemic

Investors Aren’t Fully Capitalizing on Existing Opportunities

• Total CRE transactions were 28% higher in 2021 than 2019, but Retail transactions were up only 9.4%
• Retail cap rates haven’t compressed like other properties
• Average MT-Retail cap rates hover around 6.7%, compared to 4.8% for Apartments

*Adjusted for inflation using core PCE
Core retail sales exclude auto and gasoline sales
Sources: Marcus & Millichap Research Services, U.S. Census Bureau, BEA

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Why CRE Investors Need to Keep Their Eyes on the Horizon

CRE Provides Strong Returns Over the Long Run

• Long-term outlooks allow investors to focus on meaningful demographic and macro trends, not on daily noise
• Despite recent volatility, most CRE property types have outperformed the stock market over the last 20 years
• S&P returns since 2000 were 416%; Apartment returns came in at 458%, 461% for Retail, and 848% for Industrial

Trends That Will Drive CRE Performance Over Next 20 Years

• Millennials entering family formation age will place greater focus on single-family homes and the suburbs
• Aging Baby Boomers to drive MOB and Seniors Housing demand; will progressively transfer wealth to children
• Interest rate, economic and public policy cycles will constantly transform the real estate landscape

Key Considerations for Long-Term Investments

• Take note of demographic trends, not all property types and locations will benefit equally
• Actively and periodically trade assets to capitalize on interest rate cycles and maximize ROI opportunities
• Adapt to changing behaviors, technology & public policy

*Sources: Marcus & Millichap Research Services, S&P Global, NCREIF

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Investor Insights from The Fed’s March Meeting Minutes

Fed To Take More Hawkish Approach to Combat Inflation

• Fed could implement 50 bps increases to overnight rates if inflation remains elevated, up from expected 25 bps
• Could raise overnight rates more than 200 bps this year

Balance Sheet Reduction Coming Soon

• After doubling their balance sheet during the pandemic, the Fed will begin reducing Treasury and MBS holdings
• This Quantitative Tightening should push-up longer term interest rates, would reduce risk of yield curve inversion
• Could push 10-Year Treasury above 4% by year-end

Investors Should Remain Vigilant of All the Moving Parts

• Focus on investment strategies that mitigate inflation risk and prepare for a substantial rise in interest rates
• Economic growth fundamentals remain strong, so if a recession occurs, it will be milder than recent ones
• CRE vacancies for most property types remain very low, rent growth is strong, and the investment climate is sound

*As of April 07, 2022
Sources: Marcus & Millichap Research Services, Federal Reserve

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