Will Fed rate cuts revive the US CRE market?

Rate relief in sight: How are anticipated Fed rate cuts likely to impact the US CRE investment market?

The stars appear to be lining up for a much-anticipated Fed rate cut in September. But while the start of a rate-cutting cycle will be an important move in boosting investor sentiment, it will take more time for the impact to be seen in actual transaction volume.

According to the latest FedWatch data published by the CME Group, the debate is not whether or not the Fed will cut rates at the next FOMC announcement on September 18; but rather, by how much. Currently, the markets are pricing in a 25 to 50 bps cut.

The obvious disclaimer is that successfully predicting how the Fed is going to move on monetary policy is incredibly difficult. But the big question is how that rate cut – when it materializes – will impact the transaction market. One rate cut may not be enough to move capital off the sidelines, though many market participants are moving cautiously with the assumption that capital costs will come down further towards the end of the year.

Too little too late?

There is growing frustration that the Fed has waited too long to cut rates, putting the economy in a precarious position. Other countries have already started throttling back on base lending rates. For example, the Bank of Canada (BoC) reduced its overnight interest rate by 25 basis points in June, followed by a second 25 bps cut on July 24 to a rate of 4.5%.

Despite data that shows that significant progress has been made toward bringing inflation closer to the Fed’s 2% target, the Fed has been hesitant to make a move to cut interest rates. The FOMC is clearly a committee with differing views on how they interpret the data, but they’ve been clear on wanting to see consistent data that inflation is at target. However, the fear is that data often lags, and the Fed may have already missed the ideal time to cut, resulting in a not-so-soft landing that ends up disrupting the US economy.

The lag for shelter in particular, which is easily the largest component of the Consumer Price Index (CPI) and the Personal Consumption Expenditures (PCE), is huge because renters typically sign leases once a year. That's concerning, because if there's a lag with that data, or data is not being accurately captured with owner equivalent rent, then the Fed is going to see that inflation is not pacing where they want it to go. Therefore, construction and transaction activity are both going to be subdued regardless of a rate cut.

Turning point in investor sentiment

The expectation is that once the Fed starts its cut cycle, those rate cuts will continue. In fact, as of August 19th, a slim majority of economists polled by Reuters are predicting the Fed will cut interest rates by 25 basis points at each of the remaining three meetings of 2024. So, while the first cut might spur talk of activity, investors are likely to be cautious in their buying or selling as rates are still moving.

The US has been in this tight monetary policy regime for a while, which definitely has ramifications for the economy, and we still haven't seen all of those rippling effects come through. One risk is that the economy is in a position where it is more susceptible to a big downside move if there is a shock because the Fed has removed some of the resilience by slowing growth.

On a positive note, the Fed rate cut is important for sentiment because it adds some certainty as to the direction that interest rates are moving, although the speed and magnitude of those cuts is still an open question. When investors are underwriting deals, they can start to assume that maybe we don't know exactly where rates will be within one year, two years, or even within a 5-year time span, but we have greater certainty that interest rates will be where they are now or lower and we'll have the ability to recapitalize or refinance. That certainty can help investors when doing the financial analysis and projecting cash flows that ultimately support their transaction decisions.

Varied impact across property sectors

Looking at rate cuts alone, a lower Fed funds rate certainly will be more supportive of financing and refinancing commercial property, but indirectly. A lower rate environment will likely benefit CRE transaction activity and financing environment, so long as the rate decreases flow through to the CRE borrowers through the CRE lenders – CRE borrowers do not borrow at the Fed funds rate. Lower rates could also be more conducive to tighter lender spreads, if lenders are more confident in the outlook.

Brokers are on the front lines having discussions with owners who are thinking about bringing properties to the sale market, or buyers who may be out looking for deals, with the expectation that transaction activity will start picking up later this year, and in Q1 2025.

It’s also important to note that while commercial real estate is influenced by (and does influence) the economy and financial markets, it doesn’t move in lockstep with the broader economy and capital markets. While some market environments are objectively good or bad for CRE, the current market is a bit of both – some shade of grey.

Rate cuts also are not going to impact all property sectors the same. A rate reduction of 25-50 basis points before the end of the year is not going to fix the problems in the office market. It may boost transaction activity for some of the other sectors, but if there are fundamental problems within a sector’s operating performance, lower rates may not be the remedy.

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