Commercial real estate is itching for a rebound two years after start of Fed rate hikes

By Joy Wiltermuth

Demand for office leases is picking up, but interest rates are still a wild card

The U.S. stock market looks poised for its best first quarter in five years, bolstered by a resilient economy, easing inflation and expectations for interest-rate cuts in 2024.

For commercial real estate, the rebound has been far less spectacular. Overall property values remain down an estimated 21% since their peak in March 2022, according to data from Green Street, albeit with signs of stabilization two years after the Federal Reserve began lifting short-term rates from nearly zero.

Financing in recent months has also been flowing more freely from Wall Street to top landlords, even if credit remains more expensive and harder to come by for many borrowers. What seems unclear, however, is how far off a recovery in commercial real estate still might be - and what path such a recovery could take.

"There's a strong argument today that public markets will lead private markets," said Xander Snyder, senior commercial-real-estate economist at First American Financial Corp., pointing to signs of a rebound in public markets XX:DJDBK since October's lows.

Real-estate investment trusts, or REITs, have led the bounce off the bottom for much of the past 50 years - but not always. When inflation was heating up in the 1970s, prices of private commercial property climbed as public markets slumped. But in the early 1990s, following the savings and loan crisis, public prices led the charge higher.

Landlords have been facing a wall of debt coming due against a backdrop of higher interest rates, with the benchmark 10-year Treasury yield BX:TMUBMUSD10Y off the October peak of 5%, but still above 4.2%.

Snyder said that after roughly five to six quarters of price declines for commercial real estate, a disconnect remains between buyers and sellers when it comes to price.

"It narrowed over 2023, but it's still there," he said, predicting there might be another 15% to go before more of a consensus develops.

Looking for a bottom

Tougher times may still be ahead, especially in the hard-hit office sector.

Fitch Ratings said it expects office delinquencies for Wall Street's commercial mortgage-backed securities market to more than double to 8.1% in 2024, from 3.6% in February, and to touch 9.9% next year, eclipsing the rate seen in the wake of the global financial crisis of 2008-09.

Investors have been adjusting to the likelihood of fewer rate cuts this year than were anticipated only a few months ago, all while the Fed keeps up its fight to get inflation closer to its 2% annual target.

Stock-market bulls appear to be brushing aside concerns about the potential toll of higher rates on the economy and on financial assets, with equity benchmarks hitting a series of recent record highs.

The S&P 500 index SPX has shot higher in the past five months, putting it on pace for its best first quarter since 2019, according to Dow Jones Market Data. It has climbed 14% since the Fed began raising rates from near zero two years ago, while equity REITs are down 21% since March 2022.

Stages of a comeback

On a more positive note, the financing spigot for top U.S. landlords has opened back up for well-heeled borrowers.

About $19 billion in new commercial mortgage bond deals to finance properties was expected in the first quarter, roughly 1.5 times the volume for the same stretch of last year, according to BofA Global, with real-estate giant Blackstone Inc. (BX) sponsoring almost 70% of the volume in single-asset or single-borrower deals.

Blackstone President Jon Gray told Bloomberg News a few weeks ago that he thinks real-estate prices are bottoming, creating buying opportunities at beaten-down prices.

Moody's this week also reported more office loans repaying at maturity than last year, with the rates for January and February touching 48%, up from an overall 2023 rate of 35%.

"Saying the past three and a half years in commercial real estate have been brutal would be the understatement of a lifetime," said Ryan Masiello, chief strategy officer of VTS, a platform that helps landlords, tenants and others gauge leasing demand.

Yet his platform sees office-leasing demand at about 35% of pre-COVID averages, up from several years at roughly half those averages, "which is a huge step in the right direction," Masiello said Tuesday.

Furthermore, VTS now predicts that the New York City office market will see a 17% increase in demand this year from a year ago, with San Francisco anticipating a 14% uptick.

"As we think about San Francisco, it is sort of the furthest away from its prepandemic levels of demand," Masiello said.

-Joy Wiltermuth

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03-26-24 1546ET

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