The US Federal Reserve finally began cutting the Fed Funds rate last Wednesday, with an initial drop of 0.5 per cent. Fed chairman Jerome Powell also announced that two more rate cuts are likely this year and four next year.
This rate reduction, which was 25 basis points more than most economists had expected, “is an indication that the Fed has gained the needed confidence that inflationary pressures are moving sustainably toward their 2 per cent target and satisfying their mandate of price stability,” said John Beuerlein, chief economist at the Pohlad Companies, Minneapolis-based firm that provides financial services to the commercial real estate sector.
According to a CBRE Intelligent/Investment Brief, this rate reduction was in response to both a recent softening in the labor market and increasing confidence that inflation will fall toward the Fed’s 2 per cent target. The Fed also lowered its 2024 inflation outlook for personal expenditures to 2.3 per cent from 2.6 per cent and reduced its GDP growth forecast to 2.0 per cent from 2.1 per cent for the year.
The 0.5 per cent rate cut brings the average commercial bank rate to a range of 4.75 - 5.00 per cent. Prior to the rate cut, the best bank rate available, according to J.D. Blashaw, vice president at Orange County, Calif.-based MetroGroup Realty Finance, was either Prime based on SOFR (Secured Overnight Financing Rate) at 5.5 per cent plus 2 – 3 per cent, or 7 - 8.5 per cent.
Job growth still solid
While job growth overall is still solid, averaging 170,000 a month since April, that’s down from 227,000 new jobs reported by the U.S. Bureau of Labor Statistics in the first four months of the year and the 251,000 new jobs reported at this time a year ago.
Noting that maximum employment is the Fed’s other mandate, Beuerlein said, “The Fed now views the upside risks to unemployment to be greater than the upside risks to inflation pressures. With consumer spending being the engine of the U.S, economy, the Fed does not seek or welcome any further cooling in labor market conditions,” he added.
“Assuming that inflation pressures continue to ease, the pace of interest rate cuts will be determined by developments in the labor market,” he continued, noting, therefore, that markets will be closely watching upcoming reports related to the labor market. This includes the monthly Employment report, both non-farm payrolls and the household survey; the Fed’s Beige Book with anecdotal reports on economic conditions in the 12 Federal Reserve Districts; the JOLTS report on job openings and labor turnover; and the monthly Challenger report on hirings and layoffs.
While the reduction in interest rates will help to stabilize the commercial real estate market, the rate cut alone is not enough to have an immediate or significant impact on real estate transactions, Beuerlein contended. “The assumption is that the Fed’s actions will enable the economy to have a soft landing, which he stressed is dependent on the health of the labor market.
He suggested that this rate cut will initiate a slow decline in lending rates, but loan terms are likely to remain conservative given the uncertainty of the overall economic climate. This means low loan-to-value ratios that require more equity from current landlords to refinance at a time when NOI (net operating income) is moving lower due to higher vacancies and higher operating costs, Beuerlein continued.
Even so CBRE forecasts a 5 per cent increase in annual investment activity this year and a further acceleration in investment next year. In a CBRE Webinar, Richard Barkham, global economist at CBRE, expects another 25-bps cut this year and 150 bps next year. This, coupled with lower bond yields, is expected to usher in greater economic certainty, buoying occupier confidence and resulting in resilient demand for space across all commercial property types.
Barkham noted that benefits of a soft landing are already playing out, citing very little impact from the slowing job market so far, steady national office leasing relative to last year, stronger industrial leasing than last year, extremely strong apartment leasing, and a healthy retail sector. In fact, he suggested, that in Manhattan, which is at the leading edge of the leasing cycle, Class A office space leasing is already on the upswing. “And I would say that is true for capital markets as well.”
Grappling with competition
Despite grappling with competition from the short-term rental market and a huge increase in operating cost, Barkham suggested that the hotel sector may be entering a new cycle but with mild growth, as some hotel markets around the country are better off than others.
As a result, Barkham said, “There’s been a sea-change in investor optimism in real estate capital markets over the last couple of months, driven by the falling value of debt and also reduced nervousness about a future spike in inflation and interest rates.”
Noting that rates are holding steady and values are stabilizing, and in some sectors are firming, Barkham said, “I think capital markets activity will be a little bit of hint of next year—2025 looks set for a good rebound of capital markets activity, which, of course, means that cap rates have peaked and are unlikely to fall over the course of the next 12 months.”
But with more than $2 trillion in commercial real estate loans maturing through 2027, the majority of which will be refinanced at interest rates higher than their existing rates, Beuerlein said, “We are seeing rising servicing and delinquency rates in 2024, increasing the potential number of distressed properties. A recent CommercialEdge report noted that loan defaults and delinquencies rates rose 7.5, totaling $1.87 billion, by the end of June, a 4.5 per cent increase over the same period last year.
Valuations also have receded for many parts of commercial real estate, making refinancing more challenging despite this rate reduction. The office sector has been especially hard hit, with values dropping 30 – 70 per cent or more in core U.S markets, like Manhattan and San Francisco, depending on asset category and vacancy, according to Patrick Gildea, co-head of U.S. Office Capital Markets at CBRE.
Hotels and multifamily have fared better, with Q2 2024 sales values dropping just 5.7 per cent and 7.5 per cent year-over-year, according to a Colliers midyear Capital Markets report, causing investors to convert distressed office assets to hotels and apartments when possible. Colliers attributed the stable hotel values on the industry’s stellar performance, as travelers hit the road in droves this this year. In fact, the TSA reported a record number of passengers boarded planes in 2024.
Soft landing
However, thanks to rate cuts and a soft landing for the economy, fewer banks will fail because it allows the banks to management this crisis, making provisions for them to extend on loans that otherwise they would have to foreclose on, Barham contended. He noted, however, that there still are issues due to the decline in real estate values that need to be sorted out over the next 36 months.
“The fact that we’re not in recession and have a very friendly sort of regulatory guidance for the banks as well is allowing this to be worked through in a much more orderly process than before,” added Darin Mellott, vice president of CBRE Capital Markets Research globally, “That said, we’re still going to see a significant amount of distress, and an overexposure to real estate that some of the smaller banks in particular have will remain in place.”
“What I think this effectively means for our industry is liquidity from the banking sector isn’t going to be as abundant, so private debt funds and other will step in to fill some of the gaps,” he continued. “Rates closer to 3.4 per cent will solve a lot of problems for a lot of assets, but more distress sales are coming, especially in the office sector. But overall, I think the main implication for real estate stems from the overexposure in asset classes that some of these banks have, and that will reduce their ability to lend in the sector,” Mellott noted.
As for the economy, Beuerlein said, “The Fed’s Summary of Economic Projections (SEP) that was released after the meeting shows that the Fed believes the neutral Fed Funds rate is close to 3 per cent. While this number cannot be calculated definitively, it’s clear that the current Fed Funds rate is well above that level, suggesting that monetary policy remains restrictive,” he explained, noting that restrictive monetary policy will continue to slow overall economic growth.
“Knowing that changes in Fed policy work their way through the economy with variable lags, it will likely take some time along with additional rate cuts for economic growth to develop sustainable acceleration,” Beuerlein continued.
In conclusion, Beuerlein noted that current illiquidity in many parts of the real estate market is due to pricing uncertainty, as a result of the sharp rise in interest rates. The spread between what buyers will pay and what sellers ask has grown significantly. But with the clearer trajectory for interest rates, there will be greater agreement on where property should be priced, thus improving the volume of transactions,” he suggested.