Commercial Property Slump: How Lower Interest Rates Could Revive It

The Federal Reserve’s series of interest rate hikes, which began in 2022, has had a significant impact on the real estate market. However, anticipation of a potential rate cut this Wednesday could usher in a new phase for commercial properties, bringing much-needed relief to the sector.

Uma Moriarty, a senior investment strategist at a real estate firm near Philadelphia, is experiencing a renewed sense of optimism regarding deal-making in commercial real estate. She believes that anticipated lower interest rates will allow buyers to afford higher bids on properties.

“The transaction market is becoming quite active from the buyer’s side,” Moriarty remarked. Her firm, CenterSquare Investment Management, manages a portfolio valued at approximately $14 billion. “Buyers can reach comfortable price points, which is also favorable for sellers.”

A cut in the Fed’s benchmark rate could significantly benefit the $22.5 trillion U.S. commercial real estate sector, which has been grappling with the consequences of increased interest rates since March 2022. These hikes led to a decline in property values, a rise in mortgage defaults, and triggered the worst downturn in commercial real estate since the 2008 financial crisis.

Mark Rose, CEO of Avison Young, is optimistic about the future, stating, “We are looking at a promising 2025 and beyond. Debt is becoming available again, and equity has remained stable. Investment activity is expected to grow, including in office assets.”

Predictions from economists and futures markets indicate that Fed policymakers are likely to reduce the benchmark rate by a quarter point after their upcoming meeting. Further cuts may follow in the coming months.

Lower interest rates could invigorate struggling segments of the property market—particularly in regard to billions of dollars of apartment buildings that were purchased using floating-rate debts prior to the interest rate increases. The office market has also faced challenges, experiencing a slowdown in new lending.

Sales transactions, which had slowed across the nation in response to rising interest rates, may begin to recover. Richard Barkham, global chief economist at CBRE, noted, “We’re observing a marked increase in optimism within our capital markets business. Transaction levels had been quite low, but we’re starting to see a pickup in activity and stabilization in property values.”

CBRE has forecast that commercial sales activity could rebound to $322 billion in transactions in 2024, followed by $387 billion in 2025. This represents a 5% increase in 2024 and a 26% increase in 2025 compared to 2023.

From 2013 to 2022, the average annual deal activity was around $460 billion. This peaked in 2021, when transaction volumes reached nearly $740 billion.

However, a complete recovery is still a long way off. Rising interest rates have led to a 19% decline in commercial property values since their recent highs, as reported by Green Street, a real estate data firm.

The drop in property prices has resulted in substantial mortgage debt becoming disproportionate to the new, reduced values. This situation complicates refinancing at maturity and contributes to rising default rates.

Fitch Ratings has predicted that the delinquency rates for commercial mortgage-backed securities (CMBS) will rise from 2.3% in February to 4.5% by year-end and further to 4.9% in 2025, primarily due to increased maturity defaults. In 2023, total CMBS defaults rose to $8.6 billion, more than doubling the $3.2 billion reported in 2022.

CMBS represents a small fraction of the commercial lending market. Approximately $5.9 trillion in commercial real estate debt exists, with only $694 billion securitized—less than 12% of the overall market. Banks currently hold about half of this debt and have sought to alleviate ongoing issues by extending loans, even at below-market rates.

Close to $1.5 trillion in loans is set to mature in 2024 and 2025, according to the Mortgage Bankers Association.

Anticipated rate cuts could positively influence property values, thereby reducing the additional equity that landlords would need to invest to bridge gaps between existing mortgages and new loans.

In recent months, average commercial mortgage rates have already dropped to around 7%, down from a peak of 7.5% in October 2023 and significantly lower than the 3.5% recorded in September 2021.

There are also signs of increased refinancing activity. In 2023, commercial mortgage originations amounted to $430 billion, a 47% decrease compared to 2022. However, projections indicate that 2024 originations could reach $539 billion, marking a roughly 23% year-over-year increase.

Some data suggests that property prices are beginning to recover. Green Street’s property price index rose by 1.6% in August and has increased by 3.3% so far this year.

Peter Rothemund, co-head of strategic research at Green Street, noted, “There is a good chance that the momentum in property pricing continues as bond yields decline.”

However, the outlook for the office market is more uncertain. The segment has been significantly affected not only by rising rates but also by a persistent shift towards remote work, which has resulted in high vacancy rates, particularly in older office buildings lacking modern amenities.

Fitch has projected that CMBS delinquency rates for office properties could escalate to 8.1% by the end of the year, up from 3.6% in February, and reach 9.9% in 2025. Should these projections be realized, they would exceed default rates for office properties during the last financial crisis.

Many other areas of the debt market have also suffered. Securitized floating-rate debts, utilized by property buyers for speculative investments, have also faced challenges. Default rates for these collateralized debt obligations have risen from 1.85% in 2021 to 9.3%, as reported by Bank of America.

The majority of loans against apartment buildings constitute the approximately $80 billion of outstanding CLO debts, with many intended for repositioning properties to achieve higher rents—a strategy that has faltered in some markets.

Alan Todd, head of CMBS research at Bank of America Securities, expressed skepticism that rate cuts alone would resolve all issues. “The better properties and operators may withstand the changes, but many distressed properties will likely not survive,” he cautioned.

Source: Business Insider