Key Takeaways
The commercial real estate market may be starting to turn around, but it's not out of the woods entirely. While the pain in the commercial real estate market may have been averted thanks to a robust labor market, recent signs of a cooling do not bode well for CRE. Interest rate cuts by the Federal Reserve, while beneficial for banks and property owners, could exacerbate CRE's problems if implemented after the economy has slowed significantly.
Analysts say a struggling commercial real estate market could offer opportunities later this year, but cracks in the U.S. labor market pose new challenges for the $23 trillion industry.
The CRE market has been plagued by chronic office vacancies, rising defaults and falling valuations, and has struggled in the face of the Federal Reserve's policy of keeping interest rates high to combat inflation.
High interest rates pushed CRE delinquency rates up to 5% in May from 3.6% in the same month a year ago. One-fifth of the $4.7 trillion in outstanding U.S. CRE mortgages is due to mature this year, with market value falling by roughly 30% since the Fed began raising rates.
Amid these challenges, consistently strong job growth has provided some relief to markets, but a weakening labor market could undermine that support.
How the Job Market is Impacting Commercial Real Estate
The commercial real estate market's decline began as pandemic-era restrictions kept offices empty and workers returned to the office slower than expected: As of the first quarter, office job growth beyond 2022 was just one-third of total job growth.
One in five U.S. offices was vacant in the first quarter of this year, the highest percentage on record, and office construction has fallen 63% since the pandemic began.
The damage was limited due to the resilience of the labor market.
“Along with interest rates, job growth is probably the biggest driver of growth in the property market,” said Richard Barkham, global chief economist at property management firm CBRE.
But recent unemployment data suggests the job market is starting to lose momentum.
Fed rate cuts may not solve CRE's woes
The weakening job market could prompt the Fed to cut high interest rates, which would lower borrowing costs for commercial buyers and improve investor sentiment.
However, if the employment situation worsens significantly enough that central banks are forced to cut interest rates, the commercial property market is likely to take a hit.
“If the Fed is cutting rates because something bad is happening in the economy, that's going to be bad for the CRE industry,” said Rebecca Lockie, deputy chief economist and global head of forecasting at property management firm Cushman & Wakefield.
Torsten Slok, chief economist at Apollo Global Management, said while job growth and the overall economy are doing well, vacancy rates have not shown much improvement.
“If the Fed is successful in slowing the economy, (vacancy rates) will rise, and probably very rapidly,” Slok said in a blog post.
Others point to reasons for optimism
Rockey said the office market appeared to be nearing a bottom, although falling rents and a lack of transactions made valuing the market difficult.
“I think we're getting close to a bottom, but the price discovery to really know that hasn't happened yet,” she said, noting that some landlords continue to pull out of offices they can't rent. “We're going to see this decline in occupancy continue for the rest of the year.”
Despite the challenges, it's not all doom and gloom for the commercial real estate industry.
Multifamily, retail and industrial properties continue to perform well, JPMorgan's head of commercial real estate Al Brooks said in a recent report. “The outlook for commercial real estate for the second half of 2024 is broadly favorable,” Brooks said.
Jeff Brown, founder and CEO of private equity real estate firm T2 Capital Management, said opportunities exist in more specific areas of the market, such as student housing communities.
According to Wells Fargo, “there are many reasons to be cautiously optimistic that an economic recovery is on the way.”
“If economic growth remains as strong as currently expected, demand for CRE should remain elevated,” the bank's economists said.