A commercial building for rent in Melville, New York, April 17, 2023.
Howard Schnapp | News Day | Getty Images
The tide could be turning for commercial real estate.
The Federal Reserve began The Federal Reserve began its rate-cutting cycle in September, cutting the Fed's key interest rate by 50 basis points for the first time since 2020, while hinting that further rate cuts are on the horizon. This could provide long-awaited positive momentum to interest rate-sensitive sectors such as commercial real estate.
Lower interest rates are making debt cheaper and helping to speed up deal flow in an industry where deal activity had stalled through the second quarter of 2024. The CRE market was under pressure in the years following the first Covid closures, ending a nearly 15-year bull market amid higher borrowing costs, weak tenant demand and increased real estate supply. As a result, property values and sales declined.
The Fed's policy shift is “the most notable boost” for the CRE 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 recovery in commercial real estate,” analysts wrote in a follow-up report at the end of September.
For higher dividend paying 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-backed securities strategy at Bank of America.
“Once the Fed starts cutting rates, it will continue on that path,” promoting a sense of stability, Todd said. As the market feels more comfortable, it will “incentivize borrowers to get off the sidelines and start transacting.”
CRE sales recovery
According to Willy Walker, CEO of CRE financing firm Walker & Dunlop, in an interview with CNBC in late September, refinancing and sales volumes are already increasing as industry sentiment improves.
During the Fed's tightening cycle, rising interest rates created a standoff between buyers and sellers, with buyers hoping for lower prices while sellers clung to inflated valuations. This standoff caused the deal market to freeze, causing investors to take a wait-and-see approach, leaving many wondering what's next in the market.
But more recently, overall transaction volumes recorded their first quarterly increase since 2022 in the second quarter of 2024, driven by sales in the multifamily sector, analysts noted.
According to real estate data intelligence firm Altus Group, more than $40 billion in transactions were made in the second quarter, up 13.9% from the previous quarter but still down 9.4% year over year.
Amid rising deals and falling supply, real estate valuations appear to be improving as the MSCI US REIT Index posted a steady rise from the spring through September, Wells Fargo analysts noted in their Sept. 25 study.
While these dynamics could set the stage for a broader recovery as some key subsectors such as commercial retail real estate pick up at the same time, the path forward is likely to be mixed.
Headwind in office
The office sector 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 net absorption of office space – an industry measure used to determine the change in occupied space – was positive for the first time since 2022, occupying over 2 million square feet in the three-month period.
“Although modest, this was the best result since the fourth quarter of 2021,” analysts said. However, this small victory wasn't enough to offset rising vacancies, as supply continued to outpace demand for the tenth consecutive quarter and the availability rate rose to a new high of 16.7%.
In major cities like Manhattan, office buildings recorded an average visit rate of 77% of 2019 levels in June – the highest monthly total since the Real Estate Board of New York began tracking in February 2023.
Still, analysts at Wells Fargo point out that “headwinds still far outweigh tailwinds” as hybrid work and a slowdown in office job growth continue to weigh on demand.
Prices remain below pre-pandemic levels, with central business district office prices down 48.7% since 2019, analysts said.
Beyond the temporary pause in remote work, there are “structural challenges” that have exacerbated the industry's difficulties since the pandemic, including low demand, rising vacancies and flat-rate rents, according to Chad Littell, national director of U.S. capital markets analytics at CoStar Group.
“Recovery appears to be a long way off for the CRE office sector,” Littell said. “While other property types are gaining traction, office real estate may still have a long way to go – perhaps another year or more for prices to stabilize.”
Multi-family strength
Meanwhile, demand for multifamily real estate has increased, with net absorption reaching its highest level in nearly three years in the second quarter, according to Wells Fargo research.
That's true even as multifamily construction is booming, with the number of units completed this year set to surpass a record 500,000, according to data from RentCafe. Developers are expected to complete more than 518,000 rental units by the end of 2024.
The multifamily sector was a pandemic darling within commercial real estate as rental growth hit double digits in 2021. However, this growth rate has since slowed to around 1%.
But this increase in demand signals a shift in consumer behavior as “households benefit from greater housing availability, generous concessions and more manageable rent growth,” Wells Fargo said.
One of the factors pushing renters to purchase multifamily properties is the lack of affordable, entry-level single-family homes. This trend is underscored by the stark contrast between homeownership costs and rental costs: 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.
Multi-family homes also benefit from the stabilization of vacancy rates. For the first time in over two years, vacancies did not increase in the second quarter and remained stable at 7.8%. This stabilization, coupled with the average rent increase of 1.1%, suggests a healthier balance between supply and demand.
Looking forward, the outlook for the multifamily housing sector remains positive.
Wells Fargo's analysis found that “high home ownership costs should continue to support rental demand,” meaning current trends in favor of multifamily housing are likely to continue in the near term.