Treasury Yields’ 16-Year High Holds Both Worry and Promise for Real Estate

“Our econometric models indicate that the rise in the 10-year Treasury yield to 5 percent or more, if sustained, will raise cap rates and lower capital values for commercial real estate,” the CBRE report concluded. “The increase in the 10-year Treasury yield will raise the cost of capital and make banks more cautious of lending.” 

The 10-year Treasury yield, which is less well understood than the Federal Reserve‘s federal funds rate, sets the borrowing costs for critical aspects of the American economy: government debt, home mortgages, credit card and auto debt, corporate loans, and, of course, commercial real estate loans. 

CBRE’s report, authored by Richard Barkham, Darin Mellott and Carsten Raaum, forecasts value declines of 40 percent in 2024 for national office properties. It also predicts declines of 28 percent for multifamily, 23 percent for retail, and 10 percent for industrial.  

“We’ve probably seen a 30 percent drop in value already [in office],” Barkham, global chief economist at CBRE, told CO. “It’s going further, but that’s a market average, and it’s not true of the best-grade property. You probably got a spread between the best-grade property falling 20 percent and the poorer-grade property falling 50 to 60 percent.” 

Overall, CBRE lowered growth expectations for commercial real estate investment volumes next year to minus 5 percent from plus 15 percent as previously forecast. 

Commercial real estate values are uniquely tied to the 10-year Treasury due to the quasi-fixed-income nature of real estate investment and because investors seek rates higher than the 10-year Treasury yield. This requires spreads of around 200 to 300 basis points higher than a Treasury note, so, when Treasury yields increase to 5 percent, it pushes cap rates (the potential return investors make on properties) higher, as well. Higher cap rates translate into falling CRE property values, and vice versa, a process known as cap-rate expansion (and, inversely, cap-rate compression).  

“We’ve already seen a 20 percent drop in prices over the last year or so,” explained Barkham. “The spike in the 10-year Treasury threatened another 5 to 10 percent drop in prices. It means the process of price discovery stretches longer, it takes longer for investors to reset their expectations, and it means investment transactions are slow.”  

As for the reasons behind the sudden increase of 10-Year Treasury yields, Barkham argued that the phenomena has multiple causes — some intertwined, others more stand-alone. 

September national jobs reports and payroll data have confirmed that unemployment remains historically low and wages are steady, if not increasing. Moreover, the gross domestic product grew at a 5 percent clip in the third quarter of 2023. 

Even Federal Reserve Chairman Jerome Powell seemed taken aback by the strong economic indicators during his press conference held Nov. 1 to announce a continued pause of the benchmark Federal Funds Rate. 

“This has been a resilient economy. And it’s, I think, been surprising in its resilience,” Powell said.  

While a resilient economy suggests a strong economy, it may be too strong for the appetites of cautious bond investors. 

“People think if the economy is creating jobs at that rate, that means we’ll never get rid of inflation, that means the Fed will need to push interest rates higher, and higher for longer needs to be accounted for in the 10-year Treasury,” explained Barkham. “The fear of overheating in the labor market, feeding through into inflation, feeding through into higher interest rates … is the No. 1 factor.”  

The second factor is more closely aligned with a pair of government policies. 

First, the federal budget deficit ($1.38 trillion in fiscal year 2022) expanded by 7.5 percent at the end of fiscal year 2023, compared to an annual increase of 5.2 percent at the end of the FY 2022, according to CBRE. The increase flies in the face of traditional economic wisdom, which argues federal deficits should shrink in a growing economy, due to increases in tax revenue.    

“The fact that the deficit ballooned when the economy was booming is really surprising,” said Barkham. “That then feeds the narrative that the government needs to borrow more.” 

To finance itself, the federal government issues bonds to fund its borrowing. However, the traditional stable of buyers of federal paper has shrunk in 2023. The Federal Reserve is no longer buying U.S. paper at the same rate (in fact, it has sold nearly $1 trillion in Treasury securities in the past year), while the Chinese and Japanese governments have simultaneously decreased their holdings of Treasurys, as well. 

“We have got this supply of bonds increasing, and maybe the demand for bonds decreasing, and that puts the price of bonds down and pushes yields up,” said Barkham. 

“Bond market vigilantes don’t like profligate governments,” he added. “The risks have increased for locking their money up for 10 years. Bond markets just want a premium to compensate for that risk.” 

Even amid this cloudy outlook, the storm in the bond market is unlikely to continue. CBRE expects the 10-year Treasury yield to fall to 3 percent in 2025 and remain at 3 percent over the next 10 years, “low enough to drive a recovery in real estate values,” according to the report.  

“There is too much capital in the global economy chasing too few real investment opportunities,” the CBRE report said. “So, surplus capital will once again find its way into financial markets, boosting prices and reducing yields.”

Barkham is especially bullish on the next year or two for CRE investors. Falling values and cheaper prices mean more investors can buy commercial real estate at bargain values, especially in asset classes like multifamily, industrial, and retail whose fundamentals remain sound despite the ongoing dislocation, according to Barkham.  

“That then kicks off investment markets and pushes prices up, and we think that will take place in 2024,” he said. “The near term is bleak, but the people who move first in 2024 will lock in some great rates of return that others won’t be able to.”  

Brian Pascus can be reached at bpascus@commercialobserver.com