For the first time in over four years, the Federal Reserve lowered interest rates by one-half percentage point on September 18, 2024. Policymakers plan to make one-quarter percentage point cuts at its November and December meetings, provided that inflation continues to decline — with more cuts in 2025 and 2026.
According to the National Association of Industrial and Office Parks (NAIOP), commercial real estate will benefit from this and future interest rate decreases.
The effect of interest rate cuts on CRE
The Fed’s aggressive interest rate hikes culminating in a 5% Federal Funds Rate significantly (and negatively) impacted the banking industry. These increases raised the cost of short-term borrowing for banks — including servicing deposits — although the income generated from existing loans and assets remained relatively unchanged. Consequently, bank profitability dwindled.
Banks tightened their lending standards to mitigate the impact of reduced profitability and increased funding costs. Borrowers saw stricter loan-to-value (LTV) ratios and debt-service coverage ratios (DSCRs). Higher interest rates on construction loans and commercial mortgages also affected the CRE sector. Projects became unviable, deals fell through, ongoing developments stopped — some indefinitely, property values decreased, and overall transaction volume declined.
With the Fed embarking on a rate-cutting cycle, experts anticipate these trends to reverse. Increased bank profitability will lead to greater liquidity and a willingness to extend credit. Ideally, the CRE industry will benefit from better borrowing conditions: higher LTVs (and relaxed lending standards) and lower DSCRs and interest rates. With easier access to capital, firms will be better positioned to pursue acquisitions, drive up property prices, and stimulate transaction activity.
Impact of rate cuts on fixed and adjustable interest rates
The rate cuts represent a significant opportunity for commercial real estate investors. Lower rates make financing deals more accessible and cost-effective, potentially increasing ROI. The lower rates may also attract more investors to the market, leading to more competition and potentially higher property values.
Impact of the rate cuts
A lower cost of capital
The greatest benefit of an interest rate cut? Capital costs less to borrow — and financing is an essential component of the real estate equation. High interest rates drive up borrowing costs, choking deal-making and reducing potential cash flow (and profits!) because more funding must be allocated to debt servicing rather than property reserves or investor distributions.
Conversely, lower interest rates can significantly reduce borrowing costs, boosting cash flow and investment returns. When debt service obligations decrease, investments retain more capital, leading to higher investor distributions.
For example, a syndication group purchasing a $15 million multifamily property might have faced a 6.5% interest rate before the rate cut, but after rates dropped, they secured financing at 5.5% or lower. A 1% reduction may seem minimal, but over time it accumulates, generating significant savings over the loan term, directly impacting the overall ROI and increasing investor payouts.
Higher property values
Lower interest rates can stimulate demand for CRE by increasing the affordability of financing property purchases and development projects. Greater demand drives higher property values, especially in prime locations.
While it takes time for the CRE market to realize a rate cut’s full impact, changes have begun. Experts anticipate increased property listings and buyer activity through the end of the year and into 2025, especially if the Fed drops interest rates another half percent by December 31 and up to a full percent in 2025.
Again, the lower borrowing cost may drive up property values and potentially increase the value of properties purchased earlier in 2024. While rising property values can present challenges for new market investors, these values offer opportunities for current property owners who may benefit from higher equity.
Robust competition for assets
As borrowing costs decline, more investors may enter the CRE market. Increased competition could generate bidding wars for prime properties, especially in markets with limited inventory. While these “wars” could drive up prices, they underscore the importance of a robust, versatile investment strategy. Investors should:
- Define their long-term financial goals
- Consider building a diverse investment portfolio such as different markets and asset classes
- Evaluate how (and which) commercial real estate investments can generate passive income
Buyer demand has increased since September’s rate cut, so prices will continue to rise. Net absorption remains negative for office space, but demand has improved. The industrial sector also remains strong, with rental growth at 5.5$ and sales totaling over $30 billion from January to July 2024, according to one California-based property management and leasing company. Q2 2024 saw the CRE market generate nearly $60 billion in transaction volume (31% higher than $1), according to CoStar.
Cap rates compressing
Representing the ratio of a property’s net operating income (NOI) to its purchase price, cap rates may compress even as interest rates decline — especially in high-demand areas. For example, one CRE advisor predicts that the cap rates for Class A properties will average 5% to 6% in the sunbelt and that for Class B properties, it will average 6% to 8%.
CRE Daily predicts cap rates have peaked, although the office sector remains unstable, with “cap rates increasing by 40 basis points in the past six months. Class A offices now have cap rates above 8%, indicating a higher risk premium, while Class C spaces face distressed pricing with cap rates in the low teens. The widening spread between lower and upper cap rate estimates highlights growing uncertainty in office sector pricing.”
The Fed’s signaling for future rate cuts will lead cap rates to compress — not expand. Investing now, as rates come down, empowers investors to position themselves to maximize returns in the future.
Impact of rate cuts on distressed real estate
Will the rate cuts help CRE? Maybe. S&P estimates the average rate on maturing CRE debt in 2024 is 4.3%. Debt originating this year? Its average rate is 6.2%. “We expect a modest increase — about 6% — in CRE mortgages coming due from 2024 to 2025, but 2026 should be a much tougher year, as we predict the total will rise by nearly 15%.
“It bears noting that many CRE loans set to mature in 2024 will be extended to 2025 and beyond as bank regulators are allowing lenders to work with borrowers rather than force maturity. Extensions could provide borrowers some cover in the short term and give lenders time to work out troubled credits and selectively prune their CRE portfolios through strategic sales in the secondary market. But some borrowers could need rates to move notably lower for refinancing to be viable.”
Of the mortgages maturing in 2024, 10% are office properties — a higher percentage than in 2023. However, S&P also expects this ratio to decline in future years.
Invest now, or wait?
Whether you take a wait-and-see approach or dive into an investment depends partly on your appetite for risk. Your money could sit in the bank as the Fed continues to cut interest rates, but while borrowing becomes cheaper, the competition increases. You could find the right property now for a higher cost to borrow and then refinance later to take advantage of lower interest rates in the future.
Acting now may enable investors to secure favorable financing terms and increased cash flow, profit from rising property values, hedge against inflation, and capitalize on the solid long-term potential of the market.
Are you a commercial real estate investor — or looking for a specific property to meet your company’s needs? We invite you to talk to the professionals at CREA United: an organization of CRE professionals from 92 firms representing all disciplines within the CRE industry, from brokers to subcontractors, financial services to security systems, interior designers to architects, movers to IT, and more.
