A commercial building available for lease in Melville, New York, April 17, 2023.
Howard Schnapp | Newsday | Getty Images
The tide could be turning for commercial real estate.
The Federal Reserve began its rate cut cycle in September, cutting the Fed funds rate for the first time since 2020 by 50 basis points, while hinting that more cuts are on the horizon. This could give interest-sensitive sectors such as commercial real estate the long-awaited positive momentum.
Lower interest rates are making debt cheaper, helping to accelerate deal flow in an industry where deal activity had stalled in the second quarter of 2024. The CRE market had been squeezed in the years since the initial Covid shutdown, ending an uptrend of nearly 15 years in the face of higher borrowing costs, weak tenant demand and increased property supply. As a result, property values and sales declined.
The Fed’s policy shift is “the most notable green shot” for the CRE market, Wells Fargo analysts wrote in a Sept. 3 research note. While lower interest rates aren’t a “magic bullet,” the Fed’s easing of monetary policy is “setting the stage for a commercial real estate recovery,” analysts wrote in a tracking report in late September.
For higher dividend stocks like REITs, lower interest rates make these fixed income investments more attractive to investors. But the primary impact of rate cuts is psychological, according to Alan Todd, head of commercial mortgage security strategy at Bank of America.
“Once the Fed starts tapering, it will continue on that path,” which adds to the sense of stability, Todd said. As the market feels more comfortable, “it will incentivize borrowers to get off the sidelines and start trading.”
CRE Sales Recovery
Refinancing and sales volumes are already increasing as industry sentiment improves, according to Willy Walker, CEO of finance firm CRE Walker & Dunlop, in an interview with CNBC in late September.
During the Fed’s tightening cycle, rising interest rates caused a showdown between buyers and sellers, with buyers hoping for lower prices while sellers clinging to inflated valuations. That impasse has frozen the deal market, prompting investors to adopt a wait-and-see mentality, leaving many wondering what’s next for the market.
But more recently, overall transaction volumes posted their first quarterly rise since 2022 in the second quarter of 2024, driven by sales in the multifamily sector, analysts noted.
More than $40 billion in transactions took place in the second quarter, a 13.9 percent jump from the quarter but still down 9.4 percent year over year, according to real estate information firm Altus Group.
With deals in place and supply dwindling, real estate valuations appear to be improving as the MSCI US REIT Index showed a steady rise from spring through September, Wells Fargo analysts noted in a Sept. 25 survey.
While this momentum could set the stage for a broader recovery, with some important subsectors such as commercial retail real estate recovering in tandem, the path forward will likely be uneven.
Headwinds in the office
The office sector of the CRE market continues to face a number of challenges, despite 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 occupied during the three-month period.
“Although modest, this was the best performance since Q4 2021,” according to analysts. However, this small victory was not enough to offset rising vacancies, as supply continued to outpace demand for the 10th consecutive quarter, pushing the vacancy rate to a new high of 16.7%.
In major cities like Manhattan, office buildings in June had an average occupancy rate of 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 point out that “headwinds continue to greatly outweigh tailwinds,” with hybrid work and slowing office job growth continuing to weigh on demand.
Prices remain below pre-pandemic levels, with central business district office prices down 48.7% since 2019, according to analysts.
Beyond the temporary shutdown of remote work, there are “structural challenges” that have exacerbated the industry’s post-pandemic difficulties, including weak demand, rising vacancies and flat rents, according to Chad Littell, US Capital’s national director Markets Analytics at CoStar Group.
“Recovery seems distant,” for the CRE office sector, Littell said. “While other property types are finding their feet, office may have a longer road ahead – perhaps another year or more before prices stabilize.”
Power of many families
Multifamily real estate assets, on the other hand, have seen a surge in demand, with net absorption reaching the highest level in nearly three years in the second quarter, according to Wells Fargo research.
That’s even as multifamily housing construction surges, with completed units on track to top 500,000 this year, according to data from RentCafe. By the end of 2024, developers are set to complete more than 518,000 rental units.
The multifamily sector was a pandemic CRE favorite as rent growth reached double digits in 2021. But that growth rate has since slowed to about 1%.
However, this increase in demand indicates a shift in consumer behavior as “households take advantage of greater apartment availability, generous concessions and more manageable rent growth,” Wells Fargo said.
Among the factors pushing renters into multifamily is the lack of affordable entry-level single-family homes. That trend is underscored by the stark contrast between the cost of owning and the cost of renting: The average monthly mortgage payment reached $2,248 in the second quarter, 31% higher than the average monthly apartment rent of $1,712, Wells Fargo said.
Multifamily also benefits from stabilizing vacancy rates. For the first time in two years, vacancies did not increase in the second quarter, holding steady at 7.8%. This stabilization, combined with average rent growth of 1.1%, suggests a healthier balance between supply and demand.
Looking ahead, the outlook for the multifamily sector remains positive.
Wells Fargo’s analysis suggested that “the high cost of home ownership should continue to support rental demand,” meaning current trends favoring multifamily housing are likely to continue in the near term.