Are higher rates to blame for commercial real estate's woes?

While higher rates have changed the landscape for CRE, the sector faces continued pressure from shifting demand for space in a post-pandemic environment. Admittedly, the US economy finds itself in a strange place in mid-2023, with alternating indications of weakness and strength splashed across financial headlines. The high degree of uncertainty regarding the near-term outlook has complicated the ongoing effort to determine when the Fed will end its tightening cycle, and subsequently, when CRE will potentially hit bottom. Many economists have forecast a recession in the second half of 2023, but even a contraction in growth is unlikely to bring interest rates back to their pre-pandemic levels. In the 10 years following the end to the great financial crisis (in mid-2009), effective Fed Funds averaged just 0.52%; by contrast, the effective rate stands at 5.15% today.

Higher rates aren’t the only force putting the squeeze on commercial real estate, but they are one of the most critical ones. That said, higher rates can’t explain the entirety of the sector’s weakness — and in particular, the continued lackluster demand for office product, which has emerged as a hot topic as of late.

Not a roller coaster for interest rates, but an elevator

As recently as the first quarter of 2022, the Fed’s benchmark interest rate was essentially zero, which translated to ample cheap money for real estate deals. By the spring of 2022, however, inflation pressures had proliferated throughout the economy, with US consumer price inflation reaching the highest rate in roughly 40 years (9.1%).

A number of factors drove prices (and then wages) higher during the most recent inflationary spell. Supply-chain challenges led to rising commodity and import prices, while pandemic-induced demand for goods added to pricing pressure. Perhaps somewhat perversely, one of the catalysts for high inflation has been the real estate sector – and specifically residential rents, since the cost of shelter represents 35% of the Consumer Price Index (CPI). This year, residential rental growth has decelerated, and is even reversing course in a few places. But in 2021 and 2022, apartment rents spiked due to pent-up demand from those who had shelved plans to rent during the height of pandemic lockdowns.

Despite a 4% headline CPI rate in May 2023 (which represented the smallest 12-month increase in more than two years), it is clear that while inflation is heading in the right direction, the Fed’s work is not done. Moreover, the spike in interest rates has also spooked banks and other lenders, who have tightened their lending standards in earnest. As a result, borrowing costs for CRE have become more expensive — assuming one can find lenders willing to lend in the current environment. In this environment, it has become much harder to make a CRE deal pencil; that is, to ensure the deal will provide the kind of returns that make it worth pursuing.

A $1.5 trillion wall of existing real estate loans, many of which were taken out just before or after the worst of the pandemic, will need to be refinanced by 2025. Borrowers, fearful that investments underwritten when policy rates were near zero - now no longer make sense, may be reluctant to refinance at today’s higher rates. This sets up a wave of possible defaults for many of those loans. Lenders who take possession of those properties through foreclosure will likely be looking to offload these assets as soon as is reasonably possible, which could result in a wave of distressed sales.

The unpredictable economy

In a bit of a shock to financial markets, the most recent quarterly forecast from the Fed in mid-June suggested that another two interest rate hikes may be in the cards for the second half of 2023, in contrast to more dovish market expectations. Higher interest rates may be the main source of troubles for the real estate industry in 2023, but not the only one: a high degree of uncertainty clouds the economic outlook. Even if the Fed stops raising policy rates by the end of the year, rates are likely to remain elevated (relative to historical) levels, which complicates prospects for multi-year development projects and acquisitions that may have a minimum 3 to 5 year hold period.

Economic data also continued to be mixed. There has been no shortage of mass layoff announcements this year from major tech firms and the banking sector alike, and economists have been forecasting a recession for the better part of a year now. But it hasn't happened – at least, not yet – which begs the question: have economists simply been wrong, or wrong in their timing? Will there be a recession this year or next? Recent indications, such as unusual strength in the job market – 339,000 net new jobs in May and a still low 3.7% unemployment rate – point to no recession in the near future. On the other hand, the US Treasury yield curve is deeply inverted (longer-dated yields are lower than shorter-dated ones) which has traditionally signaled a pending recession.

Figure 1 – Yield Curve Spreads

Office properties in particular are at risk

Commercial real estate isn't a monolith; a rising tide doesn’t lift all sectors equally. Over the last few years, apartments and industrial properties have been the most in-demand property types, resulting in increased development volume, which even still has been insufficient to keep rents from escalating. The multi-family market has benefited from a chronic undersupply of new housing in the wake of the 2007-2009 global financial crisis. In addition, high indebtedness has prevented many households from accumulating the necessary savings for a down-payment, which has led to lower-than-normal home ownership rates and in turn, higher-than-normal rates of rentership.

The industrial market has also flourished, but for different reasons. The pandemic accelerated the pace of e-commerce adoption as households shifted to greater online ordering, at the detriment of the retail sector. Still, no other sector has undergone as much change as office, with the pandemic upending the era of the five-day-a-week in-office schedule. While there have been pushes to mandate a full return to the office (and counter-pushes from employees who either want a full work-from-home schedule or a hybrid arrangement) there is no near-term catalyst for a rebound in space demand. Coupled with higher borrowing costs, the uncertainty gripping the sector has led to anemic deal volume, complicating the ability for the market to find a clearing price. Even so, the sizable decline in value in public market office valuations dwarfs the declines in private markets, suggesting to some that private market valuations may have to drop further, particularly in the wake of shortening tenant lease terms and elevated tenant improvement allowances, in addition to other concessions.

Despite all the problems office owners and landlords now face, there is still a case to be made that office will see a recovery over time, though it is unlikely that the five-day-a-week schedule that was the norm for most of corporate America, will return in full.

In 2021, the most recent year for which there is complete data, a net 464,000 establishments were created (births less deaths) leading to additional employment of nearly 1.2 million individuals. Of course, existing businesses also expand (and contract) over time, and not all new establishments, such as those in construction and manufacturing, will require dedicated office space. Yet, over time, with overall economic growth and the functional obsolescence of many older office buildings, vacancy rates will start to fall, even if it’s still too early to see signs of an incipient recovery.