Latest / Stagflation Conversations with Fexingo: High Inflation, Slow Growth, and 1970s Echoes / Commercial Real Estate Is the Stagflation Canary
Transcript
- Lucas: So commercial real estate is the part of the economy where the stagflation math hits hardest, and I think it's the story that's still undercovered. Luna: You mean because property valuations are basically just a function of interest rates and rent growth, and both are going the wrong direction? Lucas: Exactly. Take the ten-year Treasury — it's been hovering around four and a half percent. That's the risk-free benchmark. Now a typical office building might have a cap rate — that's net operating income divided by price — of, say, five and a half percent. The spread over Treasuries used to be three hundred basis points. Now it's barely one hundred. That means property prices have to fall to restore the spread, or rents have to rise sharply. Neither is happening. Luna: And rents aren't rising because the economy is growing at what, two percent real? And unemployment is 4.3 percent — not terrible, but not booming. Lucas: Right. The April jobs report showed payrolls up a bit, but JOLTS job openings fell again to about 6.9 million. That's down from over 12 million two years ago. Companies are hiring less, expanding less. So demand for office space is flat at best. Meanwhile, new supply from pre-pandemic construction is still coming online. You've got a triple hit: higher rates, weak rent growth, and oversupply. Luna: Is this uniform across property types? I feel like industrial and data centers are still pretty hot. Lucas: Not uniform at all. Industrial had a monster run during the pandemic because of e-commerce and supply chain reshoring. That's cooled a bit, but vacancy is still below five percent. Data centers are almost a different asset class — they're powered by AI buildout, and demand for computing capacity is insatiable. So those cap rate spreads are still healthy. Luna: So the pain is concentrated in office, especially older Class B and C buildings in secondary cities. Lucas: Precisely. The Chronicle in San Francisco reported that downtown office values there have fallen forty percent from the peak. In some cases, buildings are trading for less than the outstanding debt. That's where the stagflation loop gets dangerous. Banks hold a lot of that debt. Regional banks especially. If property values keep sliding, banks have to set aside more loan-loss reserves, which tightens lending, which slows the economy further. Luna: We just had Kevin Warsh sworn in as Fed chair on Friday. Do you think he'll address this explicitly? Lucas: He'll have to. The Fed's Financial Stability Report already flagged CRE as a top risk. But Warsh is seen as more hawkish on inflation, so his focus will be on getting prices under control. The tension is that higher rates worsen the CRE problem. But if he cuts rates too soon, inflation reaccelerates. It's exactly the stagflation box. Luna: And the market's pricing in — what, maybe one cut by year-end? The ten-year breakeven inflation rate is still at 2.4 percent, so inflation expectations are sticky. Lucas: Sticky is a good word. CPI came in at 332.4 for April, up from 330.3. That's annualizing around three and a half percent. Core is even higher. So the Fed can't declare victory. Meanwhile, real GDP growth for Q1 was revised up to two percent annualized, but that's largely inventory and government spending. Consumer sentiment hit a fresh record low in May, per the Michigan survey. That's classic stagflation — people feel rotten even if the headline numbers aren't catastrophic. Luna: Let's bring it back to CRE. What's the specific mechanism where stagflation makes it worse than a normal downturn? Lucas: In a normal recession, the Fed cuts rates aggressively, so even if rents fall, lower discount rates cushion property values. In stagflation, the Fed can't cut because inflation is high. So you get falling rents AND high rates. That's the gap that's squeezing cap rates. And it's not just office. Some mall properties are feeling it too, though high-end retail is holding up. Luna: I read a report from Moody's that said the national office vacancy rate hit 20.1 percent in Q1. That's a record. Lucas: Twenty point one percent. That's huge. Pre-pandemic it was around twelve percent. And that average masks downtown cores in places like San Francisco, where vacancy is over thirty percent. The buildings that are still viable are the newest, most amenitized ones. Everything else is in a race to refinance before loans mature. Luna: Speaking of refinancing, there's this wall of maturities coming due. Something like one and a half trillion dollars in CRE loans need to be refinanced by the end of next year. Lucas: Right. And at today's rates, many properties don't generate enough income to service new debt. So owners either inject more equity — if they have it — or hand the keys back to the bank. We're already seeing an uptick in distressed sales and defaults, especially on smaller properties held by regional banks. Luna: So what's the upside case? What would have to happen for CRE to avoid a full-blown crisis? Lucas: Two things. One: inflation cools enough that the Fed can cut rates a hundred basis points or more without reigniting it. Two: the economy avoids a recession and employment stays solid, so rent growth recovers. The labor market is still fairly tight — initial jobless claims just dropped to 209,000. That's low. So there's a path. But it's narrow. Luna: And the downside case is that inflation stays elevated, the Fed holds rates high, and the CRE downturn spreads to more banks, causing a credit crunch that tips the economy into recession. Lucas: Exactly. That's the stagflation doomsday loop. I'm not predicting it, but the risk is real. And the market is starting to price it in. The S&P 500 is up this week, but the Russell 2000 of small caps is up more — 3.4 percent in five days. That might reflect optimism that rates will peak. But CRE is still the canary. Luna: Before we move on, I want to mention that if you're finding these conversations useful, we keep the show ad-free and listener-supported. A handful of listeners chip in monthly through buy me a coffee dot com slash fexingo — that's literally what funds these conversations. Lucas: Yeah, it makes a real difference. And we're grateful. Luna: So back to the canary — what should investors or listeners who own CRE exposure be watching most closely? Lucas: The key leading indicator is the spread between CRE cap rates and the ten-year Treasury. If that spread widens again, it means the market is demanding a higher risk premium, which usually precedes further price declines. Also watch the delinquency rate on commercial mortgages — it's been creeping up, but it's not yet at crisis levels. And keep an eye on bank earnings calls. Regional banks will be asked about CRE exposure constantly. Luna: And the Fed's Senior Loan Officer Opinion Survey, which comes out next month, will show whether banks are tightening lending standards further. Lucas: That's the one. If we see a sharp tightening, it's a signal that the credit crunch is deepening. So far, the tightening has been gradual. But stagflation is a slow-moving process. It doesn't hit all at once — it erodes. Luna: One more thing: is there any CRE sector that benefits from stagflation? Lucas: Ironically, data centers might. Inflation pushes up the cost of new construction, which limits supply. And demand from AI and cloud computing is inelastic. So existing data centers can raise rents. Also, self-storage has done well historically in downturns because people downsize. But that's a niche. Overall, CRE is a stagflation loser. Luna: Alright, so the canary is singing. We'll see if the mine owner hears it. Lucas: Exactly. And we'll be watching.