Commercial Buildings Available for Rent in Melville, NY April 17, 2023.
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The tide could be changing for commercial real estate.
Federal Reserve System begins In the September rate cut cycle, the Fed cut the federal funds rate by 50 basis points for the first time since 2020, while signaling further rate cuts were on the horizon. This could provide much-needed positive momentum to interest rate-sensitive sectors such as commercial real estate.
Lower interest rates will make debt cheaper, accelerating deal flow in an industry where deal activity has been stagnant until the second quarter of 2024. The years after the first COVID-19 shutdowns put pressure on the CRE market, ending a nearly 15-year bull market. They face rising borrowing costs, weak tenant demand and increasing real estate supply. As a result, real estate values and sales declined.
The Fed’s policy shift is the “most notable green shoot” for the CRE market, Wells Fargo analysts said in a Sept. 3 research note. Lowering interest rates is not a “silver bullet,” but 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 such as REITs, lower interest rates make bond investments more attractive to investors. But Alan Todd, head of commercial mortgage-backed securities strategy at Bank of America, said the main impact of the rate cut is psychological.
“Once the Fed starts lowering rates, they will continue to do so,” Todd said, creating a sense of stability. As the market feels more secure, “borrowers will be incentivized to come off the sidelines and start trading.”
CRE sales recovery
Willie Walker, CEO of CRE finance firm Walker & Dunlop, said in a late September interview with CNBC that refinancing and sales volumes are already picking up as sentiment for the sector improves. spoke.
During the Fed’s tightening cycle, rising interest rates created a conflict between buyers and sellers, with buyers wanting to lower prices and sellers clinging to inflated valuations. This stalemate froze the trading market, with investors adopting a wait-and-see mentality and many wondering what would happen next for the market.
However, analysts recently noted that overall transaction volume increased on a quarterly basis in the second quarter of 2024 for the first time since 2022, driven by sales in the multifamily sector.
More than $40 billion in transactions occurred in the second quarter, up 13.9% from the previous quarter, but still down 9.4% from a year ago, according to real estate data intelligence firm Altus Group.
Wells Fargo analysts said in a Sept. 25 survey that real estate valuations have declined as the MSCI US REIT index rose steadily from spring through September amid increased trading activity and declining supply. He noted that it seems to be improving.
These dynamics could set the stage for a broader recovery, with some key subsectors, such as commercial retail real estate, rebounding in parallel, but the path ahead is likely to be uneven.
headwinds in the office
Although the office sector of the CRE market showed some signs of improvement in the second quarter, it continues to face many challenges.
Wells Fargo reports net office absorption (an industry metric used to determine changes in footprint) turned positive for the first time since 2022, with more than 2 million square feet absorbed in three months did.
“Although modest, this was the best performance since the fourth quarter of 2021,” analysts said. However, this small victory was not enough to offset the increase in vacancies, with supply continuing to outstrip demand for 10 consecutive quarters, with the vacancy rate reaching a new high of 16.7%.
In major cities like Manhattan, average office building attendance in June was 77% of 2019 levels, the highest monthly total since the Real Estate Board of New York began tracking in February 2023.
Still, Wells Fargo analysts said that “headwinds continue to significantly outweigh tailwinds,” with hybrid work and slower growth in office jobs continuing 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 disruption to remote work, there are “structural challenges” that have exacerbated the industry’s difficulties since the pandemic, said Chad Littell, national director of U.S. capital markets analysis at CoStar Group. These include sluggish demand, rising vacancy prices, and flattening rents.
Littell said “recovery seems far away” for the CRE office sector. “Other property types are gaining footing, but office may still have a long way to go. It will probably take another year or more for prices to stabilize.”
Strengths of apartment complexes
Meanwhile, demand for multifamily real estate assets is surging, with net absorption reaching its highest level in nearly three years in the second quarter, according to Wells Fargo research.
That’s even true amid a boom in multifamily construction, with more than 500,000 homes expected to be completed this year, a record high, according to RentCafe data. By the end of 2024, developers plan to have completed more than 518,000 rental units.
The multifamily sector became the darling of the pandemic within CRE as rent growth reached double digits in 2021. However, the growth rate has since slowed to about 1%.
But this increase in demand signals a shift in consumer behavior, with “households taking advantage of expanded apartment availability, generous concessions, and manageable rent increases,” Wells Fargo said. Ta.
One of the factors pushing renters toward multifamily housing is the lack of entry-level, affordable single-family housing. This trend is highlighted by the stark contrast between home ownership costs and rental costs. Wells Fargo said the average monthly mortgage payment reached $2,248 in the second quarter, 31% higher than the average monthly apartment rent of $1,712.
Multifamily housing also benefits from stable vacancy rates. The vacancy rate did not increase for the first time in more than two years in the second quarter, remaining flat at 7.8%. This stabilization, along with an average 1.1% increase in rents, indicates a healthier balance between supply and demand.
Looking to the future, the outlook for the multifamily sector remains positive.
Wells Fargo’s analysis suggests that “high home ownership costs should continue to support rental demand,” meaning the current trend favoring multifamily housing is likely to continue in the near term. are.
