Is This Time Different?

Whether or not the Federal Reserve opts to reverse course and cut the Fed fund’s target rate 25 basis points (bps) in July, as the future’s market is expecting—unwinding the rate hike implemented last December—the commercial property market is unlikely to see much of a positive boost. 

Early July’s jobs report likely provided some relief to those who feared that May’s dismal numbers signaled the start of weakness ahead. Even so, while June’s payroll figure continues to show job creation exceeding the number of new entrants into the labor force, the reality is that growth is slowing. Monthly job gains have averaged 172,000 in the first half of 2019—a healthy figure, but one that is more than 50,000 below the average monthly job gain for 2018. The number of jobs lost from contracting and closing establishments in the third quarter of 2018 (the most recent quarter for which we have data) are at the highest level since 2009. Business fixed investment—which includes nonresidential construction—is rolling over. The Institute for Supply Management’s manufacturing index has fallen, undergoing three straight months of decline. And most importantly, the Fed has failed to attain one-half of its dual mandate, as core personal consumption expenditures shows few signs of nearing its two percent target. In an environment where we’re closer to the effective lower bound of monetary policy, as Chairman Jerome Powell himself said at June’s Federal Open Market Committee press conference, “It’s wise to react…to prevent a weakening from turning into a prolonged weakening.”

Further supporting a pre-emptive policy move was Chairman Powell’s statement that “an ounce of prevention is worth a pound of cure.” But even without a change in monetary policy so far this year, yields on Treasuries have plummeted 75 bps since the end of 2018. Despite the decline, there’s been little pass-through to cap rates, however. The median cap rate for U.S. CBD office property transactions was 5.2 percent in the second quarter of 2018, 5.1 percent in the fourth quarter of 2018 and 5.0 percent in the second quarter of 2019—hardly a significant move. (In Manhattan, the median cap rate for office properties increased over the same time period.) If cap rates haven’t dropped in tandem with the decrease in Treasury rates so far, it’s unclear that an actual rate cut by the Fed will be the catalyst for sudden cap rate compression.

As indicated in the semi-annual Monetary Policy Report (released to Congress the same day as the  payroll report), the decline in Treasury yields “largely reflect[s] investors’ concerns about trade tensions and the global economic outlook, as well as expectations of a more accommodative path for the federal funds rate than had been anticipated earlier.”

In an environment characterized by so much uncertainty, the trade du jour has been the flight-to-safety trade of Treasuries, especially against the backdrop of negative yields on European sovereign debt—in Germany, France, Austria and Sweden. According to Real Capital Analytics, institutional net operating income growth on Manhattan office properties is negative; year-over-year growth in the corresponding commercial property price index through the first quarter of 2019 (which is unaffected by the underlying quality of the property or by the location of assets trading at any particular time) is also negative. A further decline in Treasury yields is unlikely to halt these trends, and certainly doesn’t draw foreign capital into the asset class when even short-term U.S. Treasury notes can provide an almost equivalent return with substantially less risk and considerably more liquidity. Even the 37 percent of bank respondents who eased lending conditions for non-farm, non-residential properties “somewhat or considerably”  (versus the 7 percent who “tightened somewhat”) have failed to see a material pick-up in loan demand from lower rates, according to the most recent Senior Loan Officer Opinion Survey from the Federal Reserve. Forty-eight percent of all bank respondents said a general decrease in the level of interest rates was not important as a possible reason for stronger CRE loan demand over the past year.

A Treasury rally induced by actual monetary policy easing is no different from a rally spurred by expectations of future rate cuts—whether due to global uncertainty or domestic factors. CRE assets in the office sector have failed to benefit from the decline in yields so far. Don’t expect the balance of 2019 to be any different.

Heidi Learner is chief economist for Savills.