Commercial building available for rent in Melville, New York, April 17, 2023.
Howard Schnapp | Newsday | Getty Images
The tide could be turning in commercial real estate.
The Federal Reserve began its rate-cutting cycle in September, cutting the federal funds rate for the first time since 2020 by 50 basis points, while hinting that more cuts were on the horizon. This may give interest rate sensitive sectors, such as commercial real estate, a long-awaited positive momentum.
Low interest rates make debt cheaper, helping to speed up deal flow in an industry where deal activity has stalled until the second quarter of 2024. The commercial real estate market has been under pressure in the years following the initial Covid lockdowns, ending a nearly 15-year bull run. General. In the face of high borrowing costs, weak demand for tenants, and an increased supply of real estate. As a result, property values and sales declined.
The Fed's policy shift is the “highest green shot” for the commercial real estate market, Wells Fargo analysts wrote in a Sept. 3 research note. While lower interest rates are not a “magic bullet,” the Fed’s easing of monetary policy “lays the foundation for a commercial real estate recovery,” analysts wrote in a follow-up report in late September.
For high-dividend stocks like REITs, lower rates make these fixed-income investments more attractive to investors. But the primary impact of interest rate cuts is psychological, according to Alan Todd, head of commercial mortgage-backed security strategy at Bank of America.
“Once the Fed starts cutting interest rates, they will continue on that path,” Todd said, reinforcing a sense of stability. As the market feels more comfortable, this will “incentivize borrowers to get off the margin and start transacting.”
CRE sales rebound
Refinancing volumes and sales have already started to pick up as sentiment around the sector improves, according to Willie Walker, CEO of CRE financing firm Walker & Dunlop, in an interview with CNBC in late September.
During the Fed's tightening cycle, rising interest rates caused a standoff between buyers and sellers as buyers hoped for lower prices while sellers clung to inflated valuations. This stagnation has frozen the deal market, causing investors to adopt a wait-and-see mentality, leaving many wondering what is next for the market.
But more recently, total transaction volume saw its first quarterly increase since 2022 in the second quarter of 2024, driven by sales in the multifamily segment, analysts noted.
More than $40 billion in transactions occurred during the second quarter, an increase of 13.9% quarter-over-quarter, but still 9.4% less year-over-year, according to real estate data intelligence firm Altus Group.
With deals up and supply down, property valuations appear to be improving as the MSCI US REIT Index showed a steady increase from spring through September, Wells Fargo analysts noted in their September 25 research.
While these dynamics could pave the way for a broader recovery, with some key subsectors such as retail commercial real estate rebounding, the path forward is likely to be uneven.
Headwinds in the office
The office segment of the commercial real estate market continues to face a number of challenges, despite some signs of modest improvement in the second quarter.
Wells Fargo reported that for the first time since 2022, net office absorption — an industry metric used to determine change in occupied space — turned positive, with more than 2 million square feet consumed during the three-month period.
“Although modest, it was the best result since the fourth quarter of 2021,” analysts say. However, this small victory was not enough to offset the rise in vacancy, as supply continued to exceed demand for the tenth consecutive quarter, pushing the availability rate to a new high of 16.7%.
In major cities like Manhattan, average visitation to office buildings in June was 77% of 2019 levels — the highest monthly total since the Real Estate Board of New York began tracking in February 2023.
However, Wells Fargo analysts note that “headwinds continue to far outweigh tailwinds,” with hybrid work and a downward shift in office job growth continuing to weigh on demand.
Prices remain below pre-pandemic levels, with CBD office prices down 48.7% since 2019, according to analysts.
Beyond the temporary disruption of remote work, there are “structural challenges” that have exacerbated the difficulties the industry has faced since the pandemic, including lower demand and higher vacancies and rents, according to Chad Littell, national director of U.S. capital markets analytics at Costar Group.
“Recovery seems far away” for the CRE office sector, Littell said. “While other property types find their footing, offices may have a longer way to go – perhaps another year or more before prices stabilize.”
Multifamily powerhouse
On the other hand, multifamily real estate assets saw an uptick in demand, with net absorption reaching a nearly three-year high during the second quarter, according to Wells Fargo research.
That's true even as multifamily housing construction booms, with completed units on track to exceed a record 500,000 units this year, according to data from RentCafe. By the end of 2024, developers are scheduled to complete more than 518,000 rental units.
The multifamily sector was a darling of the epidemic within CRE with rental growth reaching double digits in 2021. But that growth rate has since slowed to about 1%.
However, this increase in demand signals a shift in consumer behavior, as “households benefit from greater apartment availability, generous concessions and more controllable rent growth,” Wells Fargo said.
Among the factors driving renters to multifamily housing is the lack of suitable entry-level single-family homes. The trend is underscored by the stark contrast between the costs of homeownership and rental expenses: Average monthly mortgage payments were $2,248 during the second quarter, 31% higher than the average monthly apartment rent of $1,712, Wells Fargo said.
Multifamily also benefits from stable vacancy rates. For the first time in more than two years, job vacancies did not rise during the second quarter, remaining steady at 7.8%. This stability, combined with an average rent increase of 1.1%, indicates a better balance between supply and demand.
Looking ahead, the outlook for the multifamily sector remains positive.
The Wells Fargo analysis noted that “higher homeownership costs should continue to support rental demand,” meaning current trends favoring multifamily housing are likely to continue in the near term.
