What Rate Cuts Mean for Commercial Real Estate in 2024
As the market eagerly anticipates the Federal Reserve’s upcoming rate cut, investors are focused not just on when the cuts will happen but also on how they will impact the commercial real estate sector. The Fed is expected to begin reducing interest rates as early as mid-September, a move that could lower borrowing costs and stimulate economic activity, including commercial real estate. However, the impact on asset values is complex; while lower rates generally make financing more affordable, the extent to which this will drive up property prices remains uncertain, especially given the Fed’s cautious approach to inflation.
Investors should recognize that while borrowing costs might decrease, cap rates—the ratio of a property’s net operating income to its market value— do not adjust immediately; in fact, the correction roughly takes 6-9 months. This creates a brief window of opportunity where higher cap rates combined with lower borrowing costs could offer attractive investments. Yet, it’s essential to understand that waiting for rates to drop to previous lows, such as those seen in 2021, may be unrealistic, as the current economic environment and the Fed’s strategy differ from past crises. Savvy investors who act now, before cap rates tighten in response to lower borrowing costs, could secure better yields, positioning themselves advantageously for the future.
As Jerome Powell signaled potential rate cuts at the recent Jackson Hole Symposium, the market has already reacted, with Treasury yields dipping slightly. The uncertainty surrounding the exact size and timing of these cuts adds to market volatility but underscores the importance of strategic planning. Investors who stay informed and act decisively in this evolving landscape can navigate the challenges and seize opportunities in the commercial real estate market before the window closes.
The Meat
As the market eagerly awaits the anticipated rate cut by the Federal Reserve, the question on investors’ minds is not just when the rate cuts will occur but also how they will impact the commercial real estate sector across various asset classes.
The Anticipation
Recent economic forecasts suggest the Federal Reserve may begin reducing interest rates as early as next month during the FOMC meeting scheduled for September 17th-18th. This potential shift has been widely anticipated, driving the hope that these rate cuts will bring lower borrowing costs and stimulate economic activity to provide relief to various sectors, including commercial real estate.
According to most economists polled by Reuters, the Fed will cut borrowing costs by 0.25 percentage points at each of its remaining meetings in 2024.
The rationale is straightforward: as borrowing costs decrease, financing becomes more affordable. Thus, borrowers can pay more for assets, potentially driving up asset prices. However, the impact of rate cuts on commercial real estate values isn’t as simple as it might seem.
The Million-Dollar Question: How Low Will They Go?
While the Federal Reserve’s rate cuts are expected to make borrowing cheaper, the extent to which it will affect commercial real estate values is complex. Many anticipate that these rate cuts will bring the market back to where it was in 2021. However, the expectation of the Fed lowering rates back to 2021 levels is unrealistic. Historically, significant rate cuts, such as those seen during the 2008 Global Financial Crisis or the COVID-19 pandemic, were responses to extreme economic conditions. In those instances, rates were slashed to near zero to counteract the severe downturns.
The current economic environment is markedly different. The Fed’s actions today aim to moderate inflation and prevent a potential recession, not respond to an unprecedented crisis. Therefore, while we may see some rate reduction, it is unlikely to mirror the dramatic cuts of previous downturns which in 2021/2022 inflated asset values to historical highs.
The Timing of Market Adjustments
There is a misconception that if the Fed cuts the rates by 25bps, then every commercial real estate loan coupon will be discounted by 25bps overnight. This is not true in most conventional deals, especially coupons priced with U.S. Treasury Indexes. One key point to understand is that the market often prices in the expectation of future rate cuts (or increases) long before they actually occur. Realistically, the Fed’s anticipated timing for rate cuts influences the broader U.S. economy. This, in turn, affects bond prices, their yields, and, ultimately, the cost of borrowing through treasuries. Although it might seem like a straightforward correlation, the pricing of bonds and Treasuries is more often based on future expectations rather than current conditions.
For instance, in the past three months, the 10-year Treasury yield has fluctuated between 4.5% to around 3.75%. This drop, amounting to roughly 75bps, reflects market speculation about future Fed actions rather than large and dynamic shifts in daily bond trading. That movement in pricing is because, between May and mid-August, inflationary reports were released indicating that inflation was growing increasingly more tamed but other metrics like increased unemployment poised concern that a potential recession could be on the horizon. There is a myriad of relevant reports released weekly/monthly: CPI, PPI, PCE, Unemployment, and even Retail Sales—all metrics used by the Fed to measure the current health of the U.S. economy and data towards their debate on future action. As a central bank, The Federal Reserve has been more transparent today than in decades past. However, they remain hesitant to be fully transparent about their real-time opinions to do their best to safeguard economic stability and, more importantly, prevent exterior influence and/or manipulation. While at the same time, trying to weigh transparency with carefully crafted language to incubate the U.S. economy through this volatile cycle.
The Market Volatility
This lack of absolute clarity has contributed to the market’s volatility. Nobody knows precisely what the Fed will do in September or the rest of the year, but the market’s best guess is to synthesize probabilities based on headlines of report releases. The one common trend witnessed is a general stability of inflation trending lower and increasing anxiety of lower consumer spending paired with higher unemployment potentially yielding a recession if The Fed does not cut rates soon.
Hyperinflation?
The real question is how much will rates be cut, and if rates are cut too quickly, will the market witness another round of hyperinflation? A similar event occurred during the 1981 Recession when Fed Chair Paul Volcker, who was facing pressure to ease monetary policy after a period of significant rate increases to curb inflation, cut rates too quickly, and inflation increased higher than it was before. This resulted in another dramatic rise in rate increases to tame inflation and more cuts. This “double dip” contributed to a recession regardless of the Fed cutting rates—they just did this too aggressively.
In hindsight, the “error” of cutting rates too quickly in the 80s might be viewed as a lesson in the importance of maintaining a strong stance against inflation even in the face of economic downturns. Volcker’s eventual success in taming inflation is often cited as a justification for his cautious approach to easing rates, despite the economic pain caused by prolonged high rates. However, it must be noted that Volkers stewardship helped stabilize the U.S. economy for the following 20 years.
At the time of this writing Jerome Powell is addressing the Jackson Hole Symposium. He has signaled that interest rate cuts are likely coming soon to prevent further weakening of the U.S. labor market. The Fed is expected to lower rates at its September meeting, shifting from its previous inflation-fighting stance. Powell’s comments suggest that while inflation is declining, the rising unemployment rate is now a concern. The exact size of the rate cut remains uncertain, depending on upcoming economic data. This brief speech has shifted the U.S. Treasury yield market down by 10bps.
Understanding the Strategy
So, what does all this mean and how does an investor position themselves over the next 12 months?
This presents an opportunity for investors to act before the market fully adjusts. We’re in a unique period where investors can take advantage of higher cap rates before they compress to lower borrowing costs. This brief window, during which borrowing costs are expected to decrease while cap rates remain relatively high, can offer attractive investment opportunities. It has been noted that this “window of opportunity” generally lasts less than one year as data suggests that cap rate sensitivity takes approximately 6-9 months to adjust to changes in market conditions. Savvy investors who recognize this timing mismatch can potentially secure better investment yields.
To expand, cap rates represent the ratio of a property’s net operating income to its current market value. When borrowing costs fall, one might expect cap rates to tighten, as investors can afford to pay more for income-producing properties. However, this adjustment does not happen instantaneously. Currently, cap rates have stabilized at higher levels compared to a year ago. This stabilization is reflective of a market where borrowing costs have been elevated. The interplay between borrowing costs and cap rates is crucial: while lower borrowing costs might eventually lead to tighter cap rates, this process is gradual.
The Bottom Line
For buyers, this creates a brief opportunity for strategic advantage. With higher cap rates and the prospect of lower borrowing costs, there is potential to acquire properties at favorable valuations. Investors who can navigate the current market volatility and secure deals before cap rates compress further could find themselves in a strong position. For example, one might buy a property with a 6.5% cap rate while borrowing costs are at 5.5%.
Conversely, those waiting on the sidelines should be aware that waiting for a significant drop in rates back to 2021 lows might be a gamble. The market’s adjustment to lower borrowing costs and tighter financial pressures indicates that holding out for a more favorable market could lead to missed opportunities. While inflation appears to be tamed for now, other factors, including the U.S. trading deficit and increasing fiscal debt, still provide barriers to 2% index rates as foreign and domestic investors still require a “term premium” when investing in U.S. bonds. This premium will largely leave these bond buyers demanding a premium in yields (higher indexes) while some other U.S. economic challenges remain to be solved. This term premium is shown in the below chart for future index movement.
As we wait for the Federal Reserve’s decision on rate cuts, the CRE market is already reflecting some of those expectations. The key for investors is to understand that while lower borrowing costs may eventually lead to tighter cap rates, much of the anticipated cost of borrowing benefit is likely already priced into the market. By staying informed and strategic, investors can make the most of this evolving landscape and position themselves for long-term success.
