First reaction: Falling real estate debt costs
Lower policy rates are a necessary catalyst for broader interest rate declines, including CRE debt costs. The historical relationship between policy rates and debt costs is well established. Real estate debt costs are priced at a spread above certain base rates, including the Federal Funds rate. The spread changes over time. As policy rates increase, spreads onto real estate debt costs narrow, ultimately driving real estate debt costs up to maintain a premium above base policy rates. In contrast, lower policy rates also reduce pressure on debt costs, ultimately creating room for debt costs to fall, ultimately impacting real estate cap rates.
Next reaction: Lower cap rates
Reductions in real estate debt costs have historically led to lower cap rates and higher prices. Because commercial real estate investments often involve financing, real estate debt costs have historically been closely correlated with real estate cap rates (a property's net operating income divided by the property's purchase price). Since the early 2000s, the correlation between market cap rates2 and fixed debt costs3 has been very strong, at 0.85. A decrease in debt costs, typically reflecting higher prices, is very likely to lead to lower cap rates.
Next reaction: Price increase
The historical relationship between year-over-year changes in cap rates and CRE prices has been very strong. Falling cap rates and rising prices usually go hand in hand, and vice versa, for structural reasons. Property prices are part of the cap rate equation (i.e., net operating income divided by price). From the beginning of 2000 to the end of 2023, the correlation between annual changes in cap rates and prices is -0.81, indicating a very strong inverse correlation.6 Thus, historically, falling policy rates led to falling debt costs, which led to falling cap rates, which led to rising prices. We expect to see this chain reaction unfold in the coming months.
And jump into a new start
The slowdown in leasing velocity through 2023 primarily reflects occupier caution in a rising interest rate environment. While office buildings and shopping malls continue to face long-term structural demand pressures, the pace of leasing for other property types is expected to accelerate as interest rates ease and confidence in sustained economic growth returns. Ideally, a recovery in rental demand would coincide with a decline in new supply later this year and into early 2025.
Rising interest rates have stalled new construction funding for over a year, leading to a steep decline in new construction starts from the end of 2022 to the present. 5 Because new projects typically take one to two years to complete, a lack of new starts in 2023 will translate into less new supply in 2024 and 2025. When rental demand eventually recovers, the lack of new supply will create room for rents to rise. Higher rents will give investors confidence that a new growth cycle has indeed begun, attracting capital and driving up property prices.
Some risks
Just as a Fed policy shift could be the main driver of a real estate price recovery, there are risks to the direction of that policy shift. Inflation could unexpectedly spike, causing the Fed to slow its monetary policy easing. The U.S. government's upward revision of its 2023 job growth forecast, released in January, raises questions about the potential for wage growth to spur inflation.
If interest rates remain high for an extended period of time, it will delay the reduction in real estate debt costs, slowing the decline in cap rates and the rise in CRE prices. It could even lead to higher cap rates and further price declines. Additionally, higher interest rates will likely cause tenants to remain cautious and delay their rental decisions.
Our expectation that real estate prices will bottom in the second half of 2024 hinges on the Fed's confidence that inflation will move toward normalization. Assuming the Fed begins to cut rates this year as expected, the time it needs to ultimately impact cap rates could extend into 2025.
Conclusion: Prices to rise in the second half of 2024
The Federal Reserve sent a clear message on inflation and monetary policy in December and reinforced it in March. In our view, the Fed's policy shift will have a knock-on effect, leading to lower real estate debt costs and cap rates, which will boost CRE prices in the second half of 2024. While there are risks to this outlook, we believe real estate investors are ready to act given their growing confidence in interest rate cuts.
Read my full analysis in “Off the floor in '24.”