Welcome to Inside Real Estate Today. My name is Rich Hill. I'm global head of real estate strategy and research at Principal Asset Management. In this edition of Inside Real Estate Today, we're digging into the implications of Fed interest rate cuts on the commercial real estate market.

First, over the long term, there is some directional correlation between Fed funds and 10-year treasury rates. This is leading some investors to believe that, just as 10-year treasury rates rose as the Fed was hiking interest rates, so too will they decline as the Fed begins cutting interest rates. However, we believe it's more complicated than that.

Two points-- first, the correlations between changes in the Fed funds and 10-year treasury rates are actually quite low. Case in point, this time last year when the Fed was embarking on Fed cuts, the 10-year treasury rates actually rose. Secondly, we believe 10-year treasury rates are normalizing after a secular decline over the past three to four decades.

So what are our expectations for 10-year treasury rates? To be clear, we expect them to remain above 4%, and if they were to fall meaningfully below 4%, it might not be for such good reasons. It could be because the economy is weakening, where CRE fundamental growth slows, and financial conditions tighten. That might not be such a good outcome for commercial real estate.

What we are rooting for is stabilization in the 10-year treasury rate, again above 4%, but if we stabilized in the 4% to 4 and 1/4% range, we think that would be OK. Why is that OK? Well, it could be a highly accommodative backdrop for commercial real estate if 10-year treasury rates are around 4% and inflation is around 3%. That would project around a 1% real rate environment, and real rates are very important for the commercial real estate market.

So what does this all mean for returns over the next cycle? We've previously argued that fundamentals will be the primary driver of total returns over the next 10 years, compared to financially-engineered returns over the past 10 to 15 years against a backdrop of historically low interest rates. We do not expect a lot of cap rate compression. Instead, total returns are going to be driven by, one, income and, two, capital returns via NOI growth. This makes property and market selection paramount.

In 2025, we expect unlevered total returns of 5% to 6%. We expect that to rise to around 7% annualized over the next 5 years, and we expect it to be around 10% annualized over the next 10 years, in line with historical averages. It's important to note that some property types with higher NOI growth than others can outperform our return expectations, potentially meaningfully.