September 27, 2019

Executive Summary

  • Recent turbulence in short-term lending (repo) markets from increased interest rates has caused the Fed to make liquidity injections of up to $160 billion for several days since September 17.
  • The stress was caused by the confluence of the Fed’s move to reduce its balance sheet, corporate cash needs to make tax payments and sales of Treasuries to fund the federal budget deficit.
  • The Fed cut the rate paid on excess reserves to further spur interbank lending.
  • Despite concerns, financial markets remain healthy as the repo market disruptions were unrelated to the health of the financial system or broader economy.
  • Commercial real estate investment and lending volumes remain healthy.
  • Continued—although slowing—economic growth and lower interest rates underpin CBRE’s view of continued stability in property markets.

Debt markets are back in the headlines amid an evolving policy stance by the Fed, stress in the short-term lending (repo) markets and notable activity in credit markets, along with narrowing spreads for corporate borrowers. Although the current environment is fluid, CBRE finds that financial conditions remain favorable for commercial real estate without signs of excess or stress.

Figure 1: Multifamily Loan Spreads Tighten in Q2

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Source: CBRE Capital Markets and CBRE Research, Q2 2019.
Note: Reflects average spreads on 7-10 year, 55%-65% LTV, permanent fixed-rate loans closed by CBRE Capital Markets.

Figure 2: Loan Underwriting Measures Turned More Conservative in Q2

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Source: CBRE Research, Q2 2019.
Note: Amortization rate reflects the average percentage of origination balances scheduled to pay down over the loan term.

Figure 3: Commercial and Multifamily LTVs Diverge in Q2

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Source: CBRE Research, Q2 2019.

Short-term market stress

Short-term lending markets came under stress on September 16 when interest rates in the repo (repurchase agreement) market soared. The repo market involves financial institutions obtaining cash by selling government securities with the agreement to repurchase them after a short period (with interest), usually the following day. Such lending is vital to maintain proper functioning of the financial system. When these markets are disrupted, it can indicate a potential breakdown of the financial system as was the case in 2007 and 2008.

Figure 4: Secured Overnight Financing Rate

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Source: Federal Reserve Bank of St. Louis, CBRE Research, September 2019.

So, what caused market stress more recently? It was a confluence of technical factors that do not reflect an overall unsoundness of the financial system. These include:

  • The Fed’s quantitative tightening policy, reducing its balance sheet and thus reducing reserves in the system by not reinvesting proceeds from maturing securities held by the Fed.
  • The timing of corporate tax payments, which drew down reserves at banks when payments were made to the Treasury Department.
  • Treasury bond sales, as certain banks, called primary dealers, are forced to buy Treasuries before selling them to investors.

Combined, these factors reduced bank reserves—the money banks use to make payments to one another and the Fed—to low levels. As a result, short-term markets came under stress.

In response, the Fed began to inject liquidity into the short-term markets for several days to make up for the shortfall. These injections are executed via open-market operations where financial institutions can swap high-quality securities for cash from the Fed at a low interest rate for a short term (usually overnight). Additional liquidity injections will continue at least through mid-October. Beyond these open market operations, the interest rate paid on excess reserves was reduced by 30 bps on September 18 to ensure trading in the federal funds market fell within the targeted range. Fed Chairman Jerome Powell also mentioned the possibility of boosting liquidity by growing the size of the Fed’s balance sheet, which would be a reversal of its recent policy stance but would boost reserves in the system.

Lastly, continued rate cuts will help bring additional capital into the Treasury market. This is particularly true as it relates to foreign investors who can utilize a repo facility with the Fed instead of putting money directly into Treasuries. The foreign repo facility is attractive because it is ultra-safe, maintains relatively attractive short-term yields, quickly returns cash and can be used in unlimited quantities. These dynamics further drain reserves out of the system as banks are forced to hold more Treasuries. Lower rates would help diminish relative attractiveness of the Fed’s foreign repo program by attracting money back into Treasuries once long-term rates rise back above short-term rates. As investors buy Treasuries, this increases reserves as banks receive cash in exchange for the securities. With this in mind, we assess that issues in short-term debt markets will dissipate.

Broader Environment

The financial system as whole is in a much stronger position than it was in the late 2000s—interestingly, stricter reserve requirements were a contributing factor to last week’s turbulence—and economic growth remains healthy. The Federal Reserve Bank of New York’s Q3 2019 forecast is showing GDP growth of nearly 2.25%. Furthermore, the labor market is averaging 158,000 new jobs per month in 2019—more than enough to absorb new entrants and previously sidelined workers returning to the labor market. Monetary authorities also maintain room to maneuver with stable wage inflation around 3% and core personal consumption expenditures—the Fed’s preferred inflation measure—under the central bank’s 2% target. This allows for action by central bankers to ensure continued economic growth without running afoul of their price stability mandate.

Figure 5: CBRE House View: GDP & Interest Rate Five-Year Forecast

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Source: CBRE Research, August 2019.

At the same time short-term lending markets have shown signs of stress, corporate debt outstanding has risen significantly as companies take advantage of continued historically low borrowing rates. The risk premium for BB-rated bonds has decreased by 142 bps since the start of the year. Meanwhile, spread differentials—as represented by corporate BB vs. BBB rated bonds—compressed significantly this month. Consider this: On September 20, the spread differential stood at just 67 bps vs. the five-year average of 118 bps.

Figure 6: Spread Differential Narrows

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Source: Federal Reserve Bank of St. Louis, CBRE Research, September 2019.

Commercial Real Estate

Overall, U.S. real estate investment volumes were steady in H1 2019 and are in line with the past three years (Figure 7). Only retail investment volume had a notable shortfall in the first half of 2019 vs. the same period in 2018. Looking across major markets, volumes appear consistent with recent history. This occurred despite a decline in foreign capital flowing into the U.S. amid an uncertain economic and geopolitical environment. Looking ahead, we see a positive combination of lower hedging costs, relatively strong performance of the U.S. economy and sound property market fundamentals as compelling reasons for continued capital flows into the U.S.

Figure 7: U.S. Investment Volume

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Source: CBRE Research. Real Capital Analytics, Q2 2019.
*Reflects H1 2019 transaction volume.
Note: Volume includes entity-level transactions and excludes development sites.

Figure 8: Cross-Border Investment by Property Type

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Source: CBRE Research. Real Capital Analytics, Q2 2019.

Figure 9: Current Hedging Costs for Major Global Currencies

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Source: Hudson Advisors, September 2019.

In terms of debt markets, lending momentum in H1 2019 was very healthy and in line with averages over the past five years. Still, there are no signs of lenders becoming undisciplined in their underwriting. Commercial real estate lending as a percentage of GDP remains under 14%, well below the 18.3% peak that it reached at end of the previous cycle (Figure 10). While corporate markets are raising concern, CRE lending has become more conservative—with the recent exception of multifamily—as lenders react to the increased macro environment uncertainty. This is also seen in loan-to-value ratios (LTVs) as broader commercial LTVs drifted lower while multifamily LTVs began to diverge in Q2 2019.

Figure 10: Commercial Real Estate Lending as a Share of U.S. GD

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Source: CBRE Research, U.S. Bureau of Economic Analysis, U.S. Federal Reserve Board, latest data as of Q1 2019.

Figure 11: CBRE Lending Momentum Index

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Source: CBRE Research, Q2 2019.
Note: Data is seasonally-adjusted.

Figure 12: Fed Senior Bank Loan Officer Survey: Net Percentage Tightening CRE Lending Standard

Negative values = standards easing

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Source: CBRE Research, U.S. Federal Reserve Board, Q2 2019.

In summary, CBRE sees stress in the short-term lending markets as transitory. In addition, we view conditions in the capital markets as favorable for real estate investment with a notable absence of either excess or stress. Furthermore, our view is that ongoing economic growth—although slowing—will continue to support real estate fundamentals. Additionally, low interest rates and lower hedging costs will help sustain healthy investment volumes.

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