Commercial property has been in a slump. How lower interest rates could lift it out.
Uma Moriarity, a senior investment strategist at a real estate investment firm based outside of Philadelphia, is feeling better about deal-making in commercial real estate.
She credits the Federal Reserve and the lower interest rates that are expected to come as a result of a widely anticipated rate cut by nation’s central bank on Wednesday. Lower rates will mean that buyers can afford to bid more on property assets, she said.
“The transaction market is starting to get pretty aggressive from the buyer perspective,” said Moriarty, who is 32 and whose firm, CenterSquare Investment Management, manages a $14 billion portfolio. “They can get to a price that they feel more comfortable with – where a seller feels more comfortable.”
A reduction in the Fed’s benchmark rate would bring relief to the $22.5 trillion US commercial real estate market, which was shaken by a series of interest rate increases beginning in March 2022.
The increases diminished commercial property values, raised mortgage defaults, and triggered the sector’s worst downturn since the financial crisis more than 15 years ago. Now, real estate professionals are looking up.
“We’re looking at a very good 2025 and beyond,” Mark Rose, the CEO of the real estate services firm Avison Young, said. “Debt becomes available again and equity has never really left. There’s going to be investment, and I think investment even in office assets.”
Economists and the futures market predict that the Fed policy makers will trim its benchmark rate by a quarter point after their meeting on Wednesday. There are expectations further cuts could follow in the coming months.
Falling rates could help segments of the property market that have struggled, including billions of dollars of apartment buildings purchased with floating rate debts before the rate increases and also a troubled office market where new lending has been stymied.
Sales transactions, which also have been diminished nationally by higher rates, could pick up.
“We are seeing in our capital markets business substantially more optimism,” Richard Barkham, CBRE’s global chief economist, said. “We’ve been at very depressed levels of transactions and we see that trading is beginning to pick up and values are beginning to stabilize in the real estate sector.”
CBRE forecasts that commercial sales activity will rebound to $322 billion of transactions in 2024 as a result and to $387 billion in 2025, a 5% and 26% increase from 2023’s total.
Between 2013 and 2022, deal activity averaged $460 billion a year nationally, according to CBRE, with volume peaking during a surge in sales in 2021, when nearly $740 billion transactions were done.
The damage done
A full recovery, of course, is still a long way off. Rising interest rates brought down commercial values by about 19% from their most recent peaks, according to a price index published by Green Street, a real estate data firm, earlier this month.
The deteriorating prices also meant that hundreds of billions of dollars of in-place mortgage debts grew outsize in relation to the new reduced values, making loans difficult to refinance at maturity and pushing up defaults rates.
Earlier this year, Fitch projected that commercial mortgage backed security delinquency rates, for instance, would rise from 2.3% in February to 4.5% by the end of the year and to 4.9% in 2025, due in part to increased maturity defaults. In 2023, total CMBS defaults rose to encompass $8.6 billion of debt, up more than double from $3.2 billion in 2022, Fitch reported.
CMBS is just a small segment of the commercial lending market. There is $5.9 trillion of outstanding commercial real estate debt, of which $694 billion is securitized, totaling less than 12% of the overall market, according to the data from Trepp. Half is held by banks – although many have been eager to sidestep today’s problems by extending debts, even at below-market rates.
In total, about $1.5 trillion of loans is due to expire in 2024 and 2025, according to the Mortgage Bankers Association.
Rate cuts are expected to give a lift to property values, diminishing the amount of additional equity landlords must invest to bridge gaps between in-place mortgages and new loans.
In anticipation of the Fed rate cuts, average commercial mortgage rates have already fallen to around 7% in recent months, compared with a peak of 7.5% in October 2023 (and up from 3.5% in September 2021).
There are signs that refinancings are picking up as a result. In 2023, $430 billion of commercial mortgage originations were completed, according to the MBA, 47% less in dollar volume than 2022. This year, the MBA projects that $539 billion of originations will be completed – a roughly 23% increase year-over-year.
Property prices are also already bouncing back, according to some data.
Green Street’s property price index rose 1.6% in August, it said, and has increased 3.3% so far this year.
“Commercial property prices have increased over the past few months as bond yields have declined,” Peter Rothemund, the co-head of strategic research at Green Street, said in the firm’s recent property pricing report. “There’s a good chance the momentum in pricing continues.”
Reasons to worry about the office market
Optimism for an office rebound is more complicated. The segment was battered not only by higher rates, but a lasting embrace of remote work that has created lingering vacancy rates, especially in older, less-amenitized office properties.
Fitch has predicted CMBS delinquency rates for office buildings could jump to 8.1% by the end of the year from 3.6% in February, and to 9.9% in 2025, a rate that would exceed default rates for offices during the financial crisis, it said.
Other pockets of the debt market have also been hit hard. Securitized floating rate debts taken by property buyers to acquire speculative investments have also struggled. Default rates for these collateralized debt obligations, or CLOs, have jumped to 9.3% from 1.85% in 2021, according to Bank of America.
Loans against apartment buildings make up the majority of the roughly $80 billion of outstanding CLO debts. The loans were taken for deals that sometimes involved repositioning a property to achieve higher rents – business plans that stumbled in some markets.
“Maybe you were or were not able to renovate the property as quickly – maybe your expenses ramped up more than you thought,” Alan Todd, the head of CMBS research at Bank of America Securities, said.
Todd said he believed that rate cuts might help some ailing CLO deals, but that cuts alone were “not a cure-all.”
“The better properties, better operators who were at the margin will be okay,” Todd said. “But you’re going to have a tail of properties that don’t make it.”
