The Future of Commercial Real Estate: Headwinds and Tailwinds
Written By: Sloan Smith, MBA, CAIA, CPWA®
In 2022, the Federal Reserve increased short-term interest rates at a historically swift pace as a means to hinder inflation. The rate escalation created an interesting dynamic in the commercial real estate market. Higher borrowing costs made it more expensive for investors to finance both commercial real estate acquisitions and developments. More importantly, it had a significant impact on real estate capitalization rates (i.e., cap rates), calculated by dividing the net operating income of a property by the property’s asset value. Ultimately, cap rates started to soar, and property values declined substantially, due to the higher cost of capital and a decrease in demand for commercial real estate.
By 2023, that drop in values was felt across all the main real estate sectors (i.e. office, multi-family, industrial, and retail), but mostly in areas like office, where there was excess supply and low demand from tenants. However, even though commercial real estate has experienced its struggles and still faces numerous headwinds, it appears that the sector may be close to the end of this down cycle, especially if the Federal Reserve becomes more accommodative with monetary policy. Looking forward, it is key to monitor the potential headwinds and tailwinds, especially if real estate will be a part of your greater asset allocation.
Headwinds:
Large Amounts of Maturing Debt - Commercial real estate maturities will rise to $929 billion in 2024, which represents 20% of $4.7 trillion in outstanding loans.[1] The increase in the numbers of loans maturing this year has raised concerns about default risk. Numerous loans that were set to mature in 2023 have already been extended, which has limited delinquencies, but the greater risk of credit losses, especially in the office sector, has increased.
Minimal Transaction Activity - Total investment volume is expected to decrease by only 5%, year-over-year, in 2024, stabilizing after a 45% drop in 2023.[2] Lower levels of investment activity are driven by the expectation that the 10-year Treasury yield will remain high throughout the year. This issue could lead to distress for highly leveraged assets, such as office buildings, that utilized floating-rate debt during a lower interest rate environment.
Further Cap Rate Increases - It is difficult to forecast when real estate values for most property types will begin to stabilize. Cap rates, excluding those for office assets, increased by roughly 150 basis points between early 2022 and late 2023, depending on market and asset type.[3] Office cap rates rose by at least 200 bps. This implies a 20% decline in value for most property types. For example, CBRE Capital Markets thinks cap rates will expand by another 25 to 50 bps in 2024, with a corresponding 5% to 15% decrease in values.[4]
Tailwinds:
Strong Fundamentals - Fundamentals remain strong across sectors like industrial, multifamily, and retail. Increased consumer spending has lifted retail, while a limited housing supply has supported the multi-family sector. Growth tailwinds, especially in areas such as e-commerce, have also enhanced demand for the industrial space. Office remains the biggest concern, despite national occupancy rates continuing to improve. Occupancy surpassed 50% in 2023 for the first time since the start of the Covid-19 pandemic. It currently sits around 52%, providing an encouraging sign that vacancy rates may peak.[5] Fundamentals differ by market, and some fast-growing cities, especially in the Sun Belt region, have seen strong demand in the office space due to more stable trends in occupancy.
Demographic Changes - Ongoing growth in less dense markets has created tremendous opportunities in commercial real estate. For example, Sun Belt states now hold about 50% of the national population (326 million), which is projected to rise to approximately 55% by 2030. Over the past decade, the region accounted for 75% of total U.S. population growth (15 out of the total 21 million).[6] These dynamics should greatly initiate growth in urban areas and increase household wealth, which could drive potentially substantial commercial real estate appreciation.
Potentially Lower Interest Rates - Falling interest rates amid solid real estate fundamentals would stimulate real estate capital markets activity above currently low levels. Considering that some of the financing utilized by commercial real estate investors is floating rate in nature, it would provide a reprieve from sizable debt payments currently in play.
The commercial real estate sector has experienced a massive transition since the Federal Reserve started raising interest rates in 2022. We have seen cap rates increase across all the core real estate sectors, a substantial slowdown in transaction activity, and a maturing debt wall come to the horizon. However, relatively strong fundamentals, along with changing demographics and potentially lower interest rates, have created an environment where thoughtful allocations in the commercial real estate space could lead to robust future returns. For example, at the trough of the last three real estate cycles (early 1990s, the Tech Bubble, and the Global Financial Crisis), the subsequent five-year annualized return on commercial real estate equity has been approximately 13.5%.[7] Plenty of uncertainty remains in commercial real estate, but a thoughtful allocation paired with strong active management may capture plenty of unique opportunities going forward.
[1] Mortgage Banks Association. Data as of February 2024.
[2] CBRE U.S. Real Estate Market Outlook
[3] Ibid
[4] Ibid
[5] ‘Kastle Systems – Data Assisting in Return to Office Plans” Kastle, March 2024
[6] “The Rise of the U.S. Sun Belt” Clarion Partners
[7] AEW Capital Management
