Taking the First Step – Sept. 23, 2024
Last week’s move by the Federal Reserve’s Federal Open Market Committee was not only the first rate cut in four-and-a-half years, but it was unusually deep as well. With the Fed’s next opportunity to continue reducing the effective federal funds rate occurring in November, it’s clear that this 50-basis-point cut was only the first step.
It’s also clear that there’s a great deal to unpack when it comes to the implications for commercial real estate of the Fed’s new trajectory. For starters, there’s the question of how quickly the Fed will move in the months to come.
“With two meetings remaining in 2024, the Fed could lower interest rates further, which would aid investor demand for commercial real estate,” Marcus & Millichap said in a research brief the day after the FOMC’s decision was announced. This month’s 50-bp rate cut launches “what will likely be an interest rate lowering cycle that extends through next year.”
Since the FOMC’s next meeting is in November, the day after Election Day, “The question [is] whether to expect another cut to come then, or perhaps at December’s meeting, especially given the unusual circumstances: rate cuts in an economy that isn’t particularly stressed,” according to Moody’s Analytics.
Against that backdrop, Moody’s Analytics economist Twinkle Roy noted that in the months ahead, businesses should “anticipate a shift towards a moderate growth environment with a steady economic footing” as a result of the Fed’s cuts. Labor markets will be tighter, and we should expect to see persistent, yet slightly elevated, inflation.
For CRE specifically, Thomas LaSalvia, head of CRE economics at Moody’s Analytics, sees the long-term implications as similarly positive. “CRE demand drivers, such as household formation, income, employment growth [will] hold up reasonably well,” he said.
Traditionally, a lower rate for commercial lending and higher cap rate yield will encourage transactions, which in turn allows some much-needed price discovery to occur, according to LaSalvia. A lowered rate also gives borrowers a lower loan interest payment.
That said, he added that it will take more cuts and time before individuals and households can feel the impact. “While lower rates may help some needing to refinance maturing CRE loans, clarity and consensus in terms of valuations may have taken a step back,” he said.
Ross Yustein, chair of Kleinberg Kaplan’s real estate department, said the rate cut would be a positive for the availability of financing for new developments, refinancing for existing properties and relief for distressed properties. “On the other hand, half a point isn’t going to magically open the door to every project or erase all distress,” he said. “The effect will be very property-specific and will vary across sectors.”
For example, Yustein said, many hotels were financed with variable-rate loans when rates were very low. Despite decent occupancy rates, the hotels’ owners became unable to service their debt due to the more recent higher rates.
“The rate cut could enable some of them to get back into the black,” he said. “Furthermore, the prospect of further rate cuts could incentivize lenders on marginal properties to grant extensions in the hopes that their collateral will perform better in the near future.” Conversely, though, “an office building suffering from post-pandemic low occupancy may not get enough benefit from the latest and projected rate cuts.”
More broadly, Marcus & Millichap reported that “the reduction to the overnight lending rate and less upward pressure on the 10-Year Treasury — which fell to the 3.6% band in mid-September — will contribute to modestly lower borrowing costs for investors. This dynamic may help re-open the yield spread relative to cap rates. As such, additional sales activity could materialize, as elevated levels of dry powder capital await deployment.”
Still up in the air is the question of how many rate cuts the Fed will implement, how sharply the central bank cuts and over what time frame, pointed out Jahn Brodwin, a senior managing director and co-lead of the real estate solutions practice at FTI Consulting, Inc. “There is significant pent-up demand to transact – jump in now before prices rise or wait for rates to drop further and risk upward price corrections? Some borderline distressed properties with maturing debt may get a lifeline if rates come sufficiently down and soon enough.”
Finally, easier access to credit may not be the deciding factor in CRE transaction volume or pricing. “The Fed’s half point rate cut will provide debt service coverage relief for floating rate commercial mortgage borrowers which should modestly aid credit quality for commercial mortgage REITs in the near-term,” said Bain Rumohr, senior director with Fitch Ratings. “However, structural elements such as return to office policies or multifamily rent growth will ultimately have the biggest impact on collateral valuations, and loss experience, for the most at-risk asset classes as lenders work to resolve problem credits.”