Fed's Beige Book Signals a Mixed Bag of Economic Activity

Fed's Beige Book Shows Resilient Consumer, Cooling Labor Market

The Federal Reserve's latest Beige Book reveals a mixed bag for the U.S. economy: resilient consumer spending contrasting with a cooling labor market and heightened consumer price sensitivity. Yet, high interest rates are still impacting real estate transactions, especially in CRE.

Consumer spending: The Beige Book, a collection of economic information collected by each Federal Reserve District through Jan. 8, highlighted that consumer spending remained robust, especially during the holiday season. Notably, spending met or exceeded expectations in most districts, including New York. This consumer resilience has been a key driver in propelling the economy, particularly as other sectors, like manufacturing, show signs of weakness.

Economic activity: The report from the Fed districts indicated a general stability in economic activity, with little to no change. There's a sense of growing optimism among businesses, fueled partly by the anticipation of falling interest rates. This optimism is reflected in the positive future growth expectations expressed by branches across most districts.

Inflationary pressures: A key finding in the report is the easing of inflationary pressures. Businesses have noticed a marked increase in consumer price sensitivity, leading to narrower profit margins for retailers and less aggressive pricing strategies from suppliers. This trend points to a more cautious approach to pricing and spending from businesses and consumers.

Cooling labor market: The Beige Book highlighted signs of a cooling labor market across nearly all districts. More selective hiring, larger applicant pools, lower turnover rates, and easing wage pressures were observed. Firms in many districts anticipate further declines in wage growth over the coming year.

Real estate insights from the latest Beige Book:

• Boston: Industrial property market faces modest risks; life sciences properties demand weakens.

• New York: Office construction down, industrial construction up; high volumes under construction and deliveries expected in 2024 in downstate New York and northern New Jersey.

• Cleveland: Nonresidential construction rebounds with declining interest rates and economic optimism; delayed projects resuming.

• Richmond: Commercial real estate activity flat; retail, especially fast-casual restaurants, remains strong.

• Atlanta: Weakening conditions in various property segments; industrial markets report excess square footage and rising vacancies; concerns over rising commercial real estate loan maturities in 2024.

• Chicago: There is a slight increase in nonresidential construction; commercial real estate activity is stable; industrial property demand is high.

• Minneapolis: Commercial real estate flat; industrial space vacancies rise due to speculative building; office market soft with increasing tenant concessions; retail vacancies improve slightly.

• Kansas City: Bankers report unchanged credit standards and minimal modifications for CRE borrowers; concerns about future credit performance and borrower liquidity in CRE deals.

➥ THE TAKEAWAY

What they are saying: The U.S. economy is expected to grow at 2.4% in the fourth quarter, slower than before but still driven by strong consumer spending. Retail sales exceeded expectations in December, and core inflation is aligning with the Federal Reserve's target. However, the commercial real estate sector remains weak despite likely lower borrowing rates.

Cap Rates on Single-Tenant Net Lease Properties Continue to Climb

Unsurprisingly, cap rates on single-tenant net lease properties shot up even more in Q4, according to The Boulder Group. All three main groups, including industrial, office, and retail, saw higher cap rates.

Retail letdown: Retail cap rates shot up by 8 bps to reach 6.35%, as industrial cap rates rose by 4 bps to 7%. These increments were driven by delayed asset pricing adjustments to accommodate the significant surge in borrowing costs over the preceding year.

Office headache: The office sector saw a more substantial rise in cap rates, with a 14 bp increase, hitting 7.55% in Q4. The surge can be attributed to a lack of 1031 buyers, which resulted in increased property supply. The number of overall properties available rose by 11.6% from 3,662 in Q3 to 4,085 in Q4. 

Industry-wide implications: The lag in asset pricing and the increasing property supply due to the absence of 1031 buyers have contributed to these upward trends. But despite rising cap rates, the retail, industrial, and office sectors experienced growth rates of 12.7%, 9.2%, and 7.2%, respectively.

➥ THE TAKEAWAY

Tread carefully: The persistent climb in cap rates for single-tenant net lease properties means investors have to be more careful when assessing potential deals. Asset pricing has yet to catch up with the significant increase in borrowing costs. Additionally, the lack of 1031 buyers has contributed to increased property supply.