A yield curve is the relationship between interest rates and debt instruments. Investors focus on the three major types of yield curves.
A normal yield curve slopes upwards from left to right, which means lower yields on short-term maturities and higher yields on long-term maturities; this curve is indicative of a stable economy, one that allows investors to look to higher yields on their long-term investments. The steepness of the curve indicates how much the economy is expanding and growing.
Another type of curve is a flat yield curve, which indicates that the market is unsure about the future stability of the economy. In this scenario, there is little difference between long and short-term bond yields. This type of curve creates uncertainty in the economy which causes investors to look for more diverse investment opportunities.
The third type of yield curve is the inverted yield curve. This is a strong, leading indicator of an economic recession. This curve turns from high yields for shorter maturities to lower yields for longer maturities and occurs when investors have lost confidence in the short-term bond market. As investors exit the short-term bond market for the long-term bond market, thus bidding up the prices on long-term bonds, lower yields are created. A protracted duration with this type of yield curve is most assuredly a sign of a declining economy, and possibly a recession.
During a period of economic downturn, investors will hedge, seeking refuge in safer investments. Inverted yield curves generally portend a downturn in the stock market, which curiously has not yet happened.
The commercial real estate engine had been chugging along, fueled by low interest rates, for an extended period. Over the past three years, real estate has slowed as the yield curve inverted. This is, in large part, due to government spending. Excess cash in the market with fewer products to purchase has resulted in a wide swath of inflationary pressures. Subsequently, the Federal Reserve has had to manage the cost of funds and therefore increase interest rates to slow down spending in the hopes of curtailing this spiking inflation.
Since inflation began to take hold just over three years ago, the higher interest rates slowed the commercial real estate sector. Sellers continued to expect lower capitalization rates and higher prices for their properties. Purchasers, on the other hand, are dealing with higher debt markets requiring them to become more scrupulous with their real estate investments, thereby creating a malaise within the marketplace. This bilateral reaction causes “real estate stagnation”. During this stagnation period, purchasers’ and sellers’ expectations rarely align. Purchasers expect cap rates and yields on their real estate investment to be reflective of the higher interest rates of their borrowing, whereas sellers are still expecting returns like when interest rates were lower. The result is a lot of back and forth, with fewer real estate transactions making it to the closing table.
Once the stock market displays the traditional signs of weakness associated with an inverted yield curve, it is anticipated that more investors will once again pivot back to commercial real estate as their long-term investment safety net.
This should result in a revitalized commercial real estate market, akin to what we witnessed pre-inflation.
