Harold Bordwin, Principal and Co-President
At yearend 2023, the commercial real estate market continued to grapple with the challenges and changes that began over a year ago, in March 2022, when the Federal Reserve made the first interest rate increase. As a result, this period has been marked by rising interest rates, which have significantly impacted both property owners and lenders. We will delve into these key developments and explore what the future may hold for the real estate sector in 2024.
The Impact of Interest Rates on Property Values
Since 2022, rising interest rates have led to increased Capitalization Rates (CapRates), which by definition translates into decreasing property values. This scenario has particularly affected commercial properties with variable rate mortgages, expired interest rate caps, and/or upcoming debt maturities. In scenarios such as these, not only have property owners been confronted with materially higher interest rates but such property owners are dealing with lenders’ more conservative lending standards.
The Federal Reserve has not raised its Fed Funds Rate since July 2023. However, with an expected decline in rates in 2024, we anticipate several effects:
- Owners with variable rate debt will see savings, and
- Refinancing should become easier.
However, the crucial question remains: Will the anticipated rate declines be substantial enough to make a difference to a significant enough number of property owners? This depends on a number of factors.
- Rate of Decline and Timing: The sooner a bigger decrease is implemented (with a longer duration), the better. What decision the Fed makes, when is anybody’s call.
- Economic Environment: On the one hand, if the Fed decreases interest rates, the rationale behind the decrease is critical. If the rate decrease is due to continued disinflation, that’s a great sign for the economy. However, if the rate decrease is implemented because the Fed sees a recession, that’s a bad thing for the overall economy and the real estate industry, in particular.
Office Space in the Hybrid Work Era
The shift towards a hybrid work environment seems permanent, raising questions about the future of office spaces and how such space will be used or repurposed. According to Collier’s the US office vacancy rate stands at 16.4%, which is slightly higher than the prior peak seen at the height of the 2008 Global Finance Crisis. Despite governmental efforts to support the repurposing of these spaces, it’s doubtful these initiatives can fully address the oversupply of office real estate.
In light of this, owners and city planners are exploring innovative solutions. However, the success of these initiatives will depend on numerous factors, including taxes, location…location…location, market demand, and regulatory frameworks.
Retail Sector and Consumer Spending
As a major driver of the U.S. economy, the trajectory of consumer spending will be critical in shaping how well the retail sector does in 2024. Consumer spending accounts for approximately 70% of U.S. GDP. With current indicators presenting a mixed picture, it’s uncertain how consumer behavior will evolve over the next year. A decline in spending would likely trigger a recession.
Banks and Real Estate Loans
While banks currently show no overt stress related to real estate loans, vulnerability exists. A “black swan” event (an unforeseen event with extreme consequences) could force banks to sell real estate loans to achieve liquidity. In that scenario, banks would be forced to mark to market (MTM) loans that were previously being held to maturity. This could produce significant losses that could ripple across the economy.
The commercial real estate market in 2024 will likely be shaped by a complex interplay of interest rates, consumer behavior, and unforeseen events. (As of the writing of this blog, commercial shipping through the Red Sea and the Suez Canal has come to a halt and commentators are prognosticating about its overall impacts on the economy.) Property owners, investors, and lenders alike must stay informed and agile to navigate the ongoing changes and take advantage of any emerging opportunities. While uncertainties remain, proactive adaptation and strategic planning will be key to thriving in the evolving real estate market of 2024.