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What’s after “higher for longer?”

A reversion to the mean is supportive of real estate credit

October 17, 2024 | 3 min read
Kirloes Gerges
Managing Director, Portfolio Management, Principal Real Estate Debt
Troy Kort, CFA
Portfolio Manager, Principal Real Estate Investors
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At-a-glance

In this paper we explore whether interest rates are likely to stay higher for longer or revert to the mean—and the impact it could have on real estate credit returns.

  • Between Q4 2008 and Q4 2021, the standard benchmark interest rate averaged 0.5%. Rates have never been lower than during that period.
  • SOFR began rising at the beginning of 2022 and reached a 23-year high of 5.32% in Q4 2023. This is a period some call “higher for longer.”
  • Considering the longer historical time period (1987 to present), when the standard benchmark interest rate averaged 3.24%, the most recent SOFR and SOFR forward curve look more like a reversion to the mean.
  • The forward curve suggests the 1M Term SOFR rate will settle in the 3% range, which is good for real estate credit investors.

Where are interest rates headed? “Higher for longer” appears to be behind us, and the market is projecting a reversion to the mean—not a return to the near zero interest rate environment. While no one can predict the future, we believe that any of the likely interest rate scenarios bode well for investors.

“Higher for longer” has been the mantra in investment circles since Q4 2023, when the Secured Overnight Financing Rate (SOFR) reached a 23-year high. Taking into account only the period since 2009, higher for longer does seem like an accurate characterization of the recent interest rate environment. Looking forward, “higher for longer” will only persist if inflation reports occur that are a surprise to the upside.

The market is now pricing in a soft landing as the highest probability outcome, with a mild recession remaining a decent possibility. The Federal Reserve has started cutting rates, and the forward curve has SOFR settling around the long-term (1987 to present) standard benchmark interest rate average of 3.24%. If that’s correct, a reversion to the mean is a more accurate characterization of the rate outlook. This scenario, however, still presents opportunities for investors—higher returns than Q4 2008-Q4 2021, when SOFR averaged 0.5%. Other ancillary benefits for mean reversion include better loan metrics at origination, such as debt service coverage. Transactions should likely uptick as well as equity investors test the market and become more confident in their underwriting.

While the SOFR forward curve loses reliability beyond six to 12 months out, it is the accepted benchmark to give us a sense of where interest rates are headed. Acknowledging there are many market forces that affect SOFR, at the time of this writing (September 24, 2024), this is what we’re seeing in the market.

Higher for longer?

SOFR reached a high point of 5.32% in Q4 2023. This comes on the heels of a 13-year period (Q4 2008-Q4 2021) often referred to as “lower for longer,” during which SOFR averaged 0.5%.

Looking between now and 2030, the SOFR forward curve is expected to settle around 3%. That is lower than 2023- 2024 but still significantly higher than the Q1 2019 peak of 2.43% and the Q4 2008-Q4 2021 average of 0.5%. Based on the Q4 2008-Q4 2021 period in isolation (see Exhibit 1), “higher for longer” may be an accurate characterization of the interest rate environment for the foreseeable future, when compared to the most recent credit cycle.

EXHIBIT 1: Plotting SOFR from Q4 2008 makes the recent period look “higher for longer”

SOFR from Q4 2008 increasing till current day and staying high for the next 5 years
Source: CE Benchmark Administration Limited (IBA); Moody’s Analytics, Q2 2024.

Opportunity for attractive returns from real estate credit

If the current SOFR forward curve is accurate and interest rates revert over the next two years to their long-term mean, it is not likely to have a major impact on investor returns for the next several years. We feel the real estate credit opportunity will persist into the next several years and that investors should have confidence in real estate credit for some time to come.

Footnote

  1. Data is current as of the time of this writing, September 24, 2024.

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Risk Considerations
Investing involves risk, including possible loss of Principal. Past Performance does not guarantee future return. All financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed. Potential investors should be aware of the risks inherent to owning and investing in real estate, including value fluctuations, capital market pricing volatility, liquidity risks, leverage, credit risk, occupancy risk and legal risk. All these risks can lead to a decline in the value of the real estate, a decline in the income produced by the real estate and declines in the value or total loss in value of securities derived from investments in real estate. Private credit involves an investment in non-publicly traded securities which are subject to illiquidity risk. Portfolios that invest in private credit may be leveraged and may engage in speculative investment practices that increase the risk of investment loss. Investments in Private Credit may also be subject to real estate-related risks, which include new regulatory or legislative developments, the attractiveness and location of properties, the financial condition of tenants, potential liability under environmental and other laws, as well as natural disasters and other factors beyond a manager’s control.

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