Late last year, the U.S. Federal Reserve paused interest rate hikes and signaled its intention to cut rates this year, brightening the outlook for global commercial real estate in 2024. But so far, no rate cuts have materialized, and many in the industry are beginning to realize that lower borrowing costs are not a sure bet.
Opinions vary widely in the commercial real estate industry about how interest rates will move, with some hopeful that rate cuts remain on the Fed's agenda this year, while others are less optimistic.
“At the end of '23, everyone was expecting multiple rate cuts in '24, but as we got into the first few months of '24, people started to realize that their expectations were probably wrong,” said Todd Liker, co-portfolio manager of real estate opportunities strategies at Los Angeles-based real estate management firm Oaktree. “If you compare the short-term interest rate curve in January to where it is now, you can see that expectations have shifted significantly.”
He noted that expected near-term interest rate cuts over this period have fallen by 100 basis points. “If you think about someone who bought a property at a three or four cap, a 100-point change in interest rate expectations really changes how you think about the cost of holding, the length of holding and the value.”
On May 2, the Fed voted to keep interest rates unchanged, maintaining the benchmark interest rate in the 5.25% to 5.5% range that has been in place since July 2023. Chairman Jerome Powell said he expects more rate cuts to come, but that a “lack of further progress” toward 2% inflation is delaying the central bank's decision. “It will likely take us more time to gain confidence that we are on a sustainable path to 2% inflation,” the chairman said at a press conference after the announcement.
But the longer it takes, the worse the problem gets, according to Richard Mack, CEO and co-founder of New York-based property management firm Mack Real Estate Group. He believes many in the industry are holding onto assets with the view that interest rates will eventually fall. “People are paying to hold onto assets, but unless rents rise rapidly, asset prices will be forced to adjust to interest rates, rather than hoping or anticipating lower interest rates,” he said. “Essentially, you're paying to wait and see what kind of recovery happens. This is different from past cycles, when temporary cash flows made money waiting for asset values to rise.”
Other central banks are keeping rates on hold as well — at least for now. A week after the Fed vote, the Bank of England also decided to keep rates on hold, but officials have signaled a cut could come this summer. The European Central Bank is also widely expected to cut rates when it meets next month.
No “bloody tragedy” has happened yet
Private real estate groups are taking a variety of approaches to factoring the rate cuts into their underwriting. “It's a very volatile situation,” said Jordan Sloan, CEO of Harbor Group International, a Norfolk, Va.-based property management company. “I wouldn't say there's as strong a feeling as there was last fall, but… [that] “There will be a lot of rate cuts, but it looks like rate cuts are back on the agenda, at least for the time being.”
He said some mortgage borrowers got too excited about the Fed's hint of rate cuts last year and “got bold” with floating-rate loans, thinking rates had plateaued. “That was a risk. We didn't take the same approach,” he said, adding that he has been aggressively reducing floating-rate debt over the past 24 to 36 months. In 2021, about 36% of the firm's portfolio was funded with floating-rate debt. Now, that share is down to 16%.
Sloan told PERE in December that even interest rate cuts wouldn't be enough to “relieve” most people, but in May he took a more moderate tone. “We're certainly seeing more foreclosures and restructurings than we were a year ago,” he said. “But it's not the catastrophe that some were expecting.”
But other real estate firms are predicting rate cuts this year, despite uncertainty about the timing. Miami-based BGO, for example, expects two rate cuts in the second half of the year. “I've never predicted five or six. I've heard people say 10 this year,” says Ryan Severino, the firm's chief economist. “It felt like everyone was expecting rate cuts. [was] “There's too much excitement in the market. There's certainly too much excitement in the futures market based on the comments,” he said. He has always expected rate cuts to be slow and gradual.
Hopes of a pick-up in deal activity in anticipation of rate cuts largely did not materialize, with U.S. commercial real estate transactions in the first quarter of this year totaling just $71.3 billion, down 19% from 2018, according to CBRE and MSCI Real Assets. The same trend was seen in Europe, where first-quarter deal volume was $37 billion, down 26% from 2018, according to MSCI data, and in Asia-Pacific, deal volume fell 14% from 2018 to $24 billion, according to CBRE.
“I think a lot of people were hoping for a more proactive approach, and that disappointment [around rates not coming down]”But they haven't done that so far,” Severino said.
Focus on opportunities
Not everyone is expecting a rate cut. Ward Fitzgerald, CEO of EQT Exeter, the real estate arm of Swedish private equity firm EQT, said he still doesn't expect rates to be cut, a view he has held for 18 months.
“That's because even though the Fed has 'cut rates,' it's only on short-term rates, while an inverted yield curve keeps long-term rates above 4% and borrowing rates closer to 6%,” he said. He expects prices to remain sideways while forced selling accelerates, a scenario that will create more opportunities.
Morgan Stanley Real Estate Investing, the bank's real estate investment arm, believes interest rates will fall over the long term, but co-chief executive Lauren Hochfelder said interest rates aren't affecting the types of investments MSREI is pursuing, noting that the firm's approach is to invest in sectors that are performing well.
“In general, I think it's a mistake to rely too heavily on the forward curve being realized within a certain time frame,” she said. “You want to have more robust capital and assets that can withstand higher prices for a longer period of time.”
While the industry has seen a wide range of reactions to the rate cut, borrowers taking a more cautious approach have opted for a more moderate outlook on interest rates and are sticking to their investment strategies.