Lower interest rates and the Fed’s signal that it plans to cut its target for the Federal Funds rate further should be good news for investors with commercial real estate assets in their portfolios. According to industry insiders, the rate cut should generate greater interest in this alternative asset and make financing real estate deals easier, helping accelerate price discovery and value growth. The 50 basis point rate reduction, however, is too modest to solve all of the sector’s existing issues.
“The rate rolldown is a positive and anticipated event,” wrote Kevin Gannon, chairman of Robert Stanger & Co. “It will still take some time for buyers and sellers to meet on price as the rate increases over the past few years were quite substantial.”
The public real estate market serves as a leading indicator for the sector as a whole and has been pricing in anticipated rate cuts for some time, noted Richard Hill, head of real estate strategy and research at investment management firm Cohen & Steers. As of last Friday, publicly traded REITs were up 16% year-to-date, signaling that the market felt rate cuts would positively impact the broader real estate universe.
That’s important because there has been a persistent gap between public and private real estate markets in recent years. In the rising rate environment, public REITs declined much further and faster than private real estate. The FTSE Nareit All Equity Index, for example, saw a 25% decline in 2022 alone. Private real estate, particularly as measured by appraisal-based indexes, never registered that kind of drop. As of the third quarter of 2022, the spread between the appraisal cap rate for private real estate, according to the NFI-ODCE index, and the implied REIT cap rate of the FTSE Nareit All Equity Index, peaked at 244 basis points, according to Nareit analysis. The gap emerged in part because public REIT valuations change daily with market fluctuations, while the appraised cap rate for private real estate is determined quarterly and tends to move gradually. As of midyear 2024, the gap between the two cap rate measures had narrowed to 120 basis points, fueled in part by the recovery in public markets and continued adjustments on private appraisals, which have declined for seven straight quarters. Now, with interest rates normalizing, that spread could narrow further.
“Going back to the third quarter of 2022, the REIT implied cap rate was at 6.07%, and the private appraisal cap rate was 3.63%,” said Edward F. Pierzak, Nareit senior vice president of research, in an interview earlier this year. “Fast forward to today, the REIT implied cap rate through Q1 was 5.8%, and the private cap rate was 4.6%. So, on the one hand you can see the REIT implied cap rate has been somewhat consistent in its pricing while the private cap rate has increased by over 100 basis points.”
The rally in REIT prices since then has likely contributed to closing the gap further, although the extent to which will not be clear until the end of the third quarter, when the next ODCE index reading is published.
The fact that debt costs should drop, making it easier for investors with expiring debt to refinance, should also play a role in stabilizing the public and private real estate markets.
“Commercial real estate is inherently a levered asset class. While interest rates are not the only driver of commercial real estate valuations, they are an important part of the equation, especially given that interest rates have been rising fairly significantly for the better part of 2 1/2 years,” Hill said. “So, the U.S. commercial real estate market is cheering the decline in interest rates because it’s a welcome release valve.”
Cohen & Steers anticipates that prices in the private real estate sector will reach a trough in the next quarter or two, helped by lower rates and sellers’ acceptance of the drop in valuations over the past two years.
Jim Gott, senior director and head of EMEA asset surveillance for commercial real estate with Mount Street, a global loan servicing firm, also said that lower interest rates will help speed up price discovery and shore up investor interest in the sector.
One indicator of retail investors’ recent aversion to private real estate is evidenced in the decline in investment in non-traded REITs to date in 2024. Through the end of July, fundraising for non-traded REITs amounted to $3.4 billion, according to Robert A. Stanger & Co. That’s a substantial drop from both 2023 ($10.2 billion for the full year) and 2022 ($33.2 billion).
“With real estate investors focused on both space market fundamentals at the property level and the cost of capital, rate cuts attributed to eroding worry about inflation would be welcomed by investors and constructive for property valuations,” wrote John Berg, global head of private real estate with investment management firm Principal Asset Management. Berg cautioned, however, that if rate cuts are coupled with rising unemployment and concerns about broader economic performance, that may partially offset the positive impact on real estate valuations.
In the second quarter of 2024, the Commercial Property Price Index (CPPI) for all property sectors tracked by research firm MSCI Real Assets remained flat with the previous year, indicating no significant change in prices. At the same time, investment sales volume fell in every sector, ranging from a 14% drop in seniors housing to a 27% drop in retail. However, those figures marked an improvement in the sector as they signaled a leveling off from the declines in deal volume and pricing that started in 2022, MSCI researchers noted in the report.
A lower rate will have a net positive effect on the availability of financing for both new and existing properties that might have been struggling to secure a loan before, according to Ross Yustein, chair of the real estate department with Kleinberg Kaplan, a New York City-based law firm. The promise of additional cuts in coming months might also reassure lenders that they can grant extensions on loans to struggling properties in the hope that the extra time will help owners improve performance, he noted.
However, at 50 basis points, the cut is still too small to become a “magic bullet” for distress in the commercial real estate sector, Yustein cautioned.
Similarly, Hill noted that the commercial real estate recovery during this cycle would likely not follow the broad V-shaped pattern that occurred after the Great Financial Crisis because global central banks are not providing stimulus money.
“We do think we are close to the bottom, and we think this is going to be a sort of an old-school recovery in commercial real estate driven by fundamentals growth,” he said.
