Manus Clancy is head of data strategy at LightBox
For many in the Northeast, Upper Midwest, and Great Plains states, the month of February is among the worst when it comes to quality of life. Cold temperatures, boatloads of snow, and short days can create misery for denizens of those regions.
Lately it’s not just the weather making commercial real estate pros uncomfortable. A series of stronger-than-expected economic prints took some of the wind out of the sails of CRE types, forcing interest rates higher and expectations for Fed rate cuts to be reduced.
Last month we noted that there was a improving sense of optimism surrounding the CRE markets in January. The yield on the 10-year Treasury had fallen more than 100 basis points; inflation indicators were declining; and analysts were expecting as many as six rate cuts in 2024.
The optimism was particularly noticeable at this year’s MBA conference where many cocktail and cigar bar comments suggested that 2024 would not be nearly as bad as 2023. Many at the confab expected transaction activity and CRE distress to come in higher and lower, respectively, in 2024 than the apocalyptic forecasts in the headlines. In addition, many offered that a rebound would come sooner rather than later and that worst-case scenarios would be avoided.
If that polling were done today, the results might not be as upbeat.
Hotter-than-expected CPI and PPI reports this month helped douse the predictions four to six rate cuts in 2024. Those reports also helped push the yield on the 10-year Treasury up 45 basis points from its recent trough. The fact that the January jobs report (released before MBA) was also uncomfortably warm, helped turn sentiment more cautious over the last few weeks.
A surging US stock market didn’t help either. The current Nvidia-induced AI euphoria won’t make the case any easier for the Fed to cut rates in the near term. Neither will the recent trend of US companies loading up on debt and convertible securities to take advantage of the miniscule spreads to Treasury for corporate borrowing and the sky-high levels of equity values.
The late 2023 and early 2024 optimism for CRE markets came from two fronts:
- A lower 10-year Treasury rate would bring lower cap rates and higher values. Higher values would beget an easier time for CRE owners to refinance maturing debt. The lower cost of financings would also allow more purchases to “pencil” helping the overall market see better days. With the 10-year moving in the wrong direction, this optimism has tempered a bit in recent weeks (although it’s worth noting that the 10-year is still 75 basis points below its peak).
- Cuts to the Fed Funds rate would provide relief to borrowers that had taken out floating rate loans in 2020, 2021, and 2022. Lower short-term rates would help restore DSCR levels while reducing the pain of acquiring interest rate caps. Now those benefits have been largely dismissed, at least over the short-term.
What Does This All Mean?
One month obviously does not a trend make. And despite a modest trickle of CRE dealmaking activity in Q4 2023 with property listings coming in at a lackluster 13% below Q4 2022, the overall economy continues to dodge the ‘R’ word. (This week US Q4 GDP was reported at 3.2%).
Looking ahead, we ask: is the glass half full or half empty? We still expect modest downward pressure in long-term yields between now and end of the year. In addition, Fed rate cuts will come at some point – even if only to relieve pressure on banks holding big CRE loan portfolios.
These trends should eventually result in firming of CRE prices and the reducing of debt service cost. It may just be that those moves by a cautious Fed will come later than expected, to the disappointment of many in our industry. But they will come.
For those in need of more optimism during the dark days of February, here are two other considerations:
First, as we noted last month, the war chest of available cash ready to be deployed remains enormous. These funds will have to be deployed at some point. Based on preliminary data from LightBox’s RCM platform, the volume of property listings in January reached 37% of last year’s Q1 total — and a 2% increase over last January’s volume — a potential early sign of momentum in the deal-making pipeline. Once some intrepid buyers start the process, we expect the CRE economy to pick up quickly – although that may still be several months away.
Second, as we also noted last month, the volume of deeply discounted property sales has increased in recent months. In the past, we’ve mentioned sales taking place in San Francisco and Baltimore as seeing office properties sell as substantially lower prices than 5 to 10 years ago. Since then, offices sales have taken place in Chicago, Portland, and Los Angeles at similarly deep discounts. This may not seem like a reason for optimism. However, consider that a sale – even at a depressed price – is evidence that buyers are available and that price transparency is taking place.
The alternative – no transactions as all – is far worse than seeing sales take place at prices that are low by historical metrics.
The takeaway after the month of February: better days will come, but perhaps not as fast as we were counting on last month.
