Ahead of the Federal Reserve Open Markets Committee’s meeting on Sept. 20, experts near-universally expect a pause on interest rate increases. Presently, the Federal funds’ target rate of 5.25 to 5.50 percent is at its highest since 2007, and has been a precursor to diminished transaction volumes, deflated property valuations and exorbitantly high capital costs, nearly all of which do not appear likely to change in the near term.
At the same time, the industry appears to be adapting to this dealmaking market, independent of the Fed’s decisions and appears poised for long-term success, provided that the economy experiences a soft landing. Industry experts spoke to Commercial Property Executive about their short- and long-term predictions for the economy, commercial real estate dealmaking and when they predict a meaningful increase in transaction volumes.
A balancing act
With a 30-basis-point month-over-month decrease in core inflation, to 4.35 percent as of the end of August, alongside a jobs report that pointed to 187,000 new hires, a 30-basis-point increase in unemployment and a 20-basis-point increase in wage growth, the Fed’s present stance appears to have changed little. Such a perspective was exemplified further at the Jackson Hole Economic Policy Symposium, where Chairman Jerome Powell acknowledged the latest reports as a “welcome development,” yet stated that inflation remains “too high.” At the same time, Powell discussed the risks of moving too aggressively to combat it: “Given how far we have come, at upcoming meetings we are in a position to proceed carefully as we assess the incoming data and the evolving outlook and risks,” he said.
In turn, many have interpreted this language, alongside the incoming data, as making the Fed possibly more cautious in its policy, yet not tempering its conviction. “It is very likely that the Fed will take a pause in making any changes during its September meeting,” predicted Bryan Kenny, president & principal at Bandon Capital Advisors.
Still, Kenny emphasized the importance of this priority, and any possible conflicts that it may have with the current election cycle as being null. “There is a false notion that because we are in an election cycle, the Fed will lower rates next year, but we don’t believe that will happen unless there is a decline in economic growth. They have been steadfast in pursuing a target of 2 percent inflation, and we simply aren’t there yet,” he added.
Weathering the storm
With this balancing act appearing to become the norm, experts see transaction volumes and capital costs as unlikely to meaningfully change over the next few months. Rebecca Rockey, global head of economic analysis & forecasting at Cushman & Wakefield, sees possibly imminent “uncertainty,” created by a potential government shutdown, rising deficits and lending hesitancy on part of banks as the “enemies of the market.” “The markets need clarity, and the clouds are not parting just yet,” Rockey told CPE.
Materially, in the dealmaking landscape itself, more of the same persists, with possible further volatility occurring due to maturing property loans, and sellers exhausting their liquidity. “Depending on how loan maturities go over the next few quarters for all forms of real estate, lending could get even worse,” noted Drew Cunningham, partner & chief operating officer at Dilweg, a middle-market investment management firm.
In fact, one unintended consequence of the loan maturities could be concessions on the part of sellers that may face depleting liquidity reserves. Such capitulations could further narrow bid-ask spreads. Both predictions are shared by Ian Bel, managing principal & CEO of Olive Tree Holdings, who believes that this could lead to a slight uptick in transaction volumes. “The buyer-seller disconnect is likely to be bridged more by seller capitulation given the number of looming maturities,” Bel predicted. Additionally, within the lending landscape itself, Bel sees “a continued shift from traditional lending channels to private credit,” as banks deal with increasingly restrictive lending standards and capital buffers.
Kenny observes such a dealmaking environment firsthand, detailing how his firm secured the majority of loans for new deals in the “mid 5 percent (to) high 6 percent range,” something that he sees as “not a terribly high figure,” given the circumstances. “We believe we are in a ‘steady as she goes’ scenario, which is not necessarily a bad situation to be in,” Kenny added. Still, he acknowledged deals previously closed in 2019 in the 3 percent range as not being even remotely in the realm of possible for the foreseeable future.“ The last several years were an anomaly,” he reflected.
Another less-visible effect of the current lending environment has been the resurgence of demand for restructuring and workout-related skills in debt markets. Demand for such niches, largely not needed since the Great Financial Crisis, is trending upward. “This means that the 50-year-old and over professionals with experience in the area are suddenly going to be in demand for these roles,” explained Kent Elliott, principal & founder of RETS Associates, a talent-management firm that focuses on real estate. “If a candidate is 35 or younger, they have zero exposure to debt restructuring or workouts—they’ve never really seen a market where those skills were needed,” he added.
Similar to their nearly universal predictions around the Fed’s decision on Wednesday, experts’ expectations were also close regarding the time when they predict the earliest possible cut in the funds rate, as well as what its effects might be. Aaron Jodka, director of Research for U.S. capital markets at Colliers predicts the first cut as taking place sometime in the third or fourth quarter of 2024, provided that the Fed can get inflation to where it wants it to be.
Nonetheless, Jodka stresses that a cut under these circumstances can only take place if a 2 percent inflation rate appears to be the norm, long-term. “There is volatility here, it is not always a smooth path from 9 percent inflation down to 2 percent,” Jodka told CPE. “It could be some time before the Fed feels that it has inflation at 2 percent, and even if we have some reads at 2 percent, the Fed is going to want to see it stay there,” he added.
In a similar vein, others anticipate that once the Fed begins to cut rates, it will do so far slower than it raised them. “We predict that the Fed will reduce rates much slower than it will raise rates,” noted Diana Shkodina, managing director at KPMG, who predicts the first cut in May of 2024. Shkodina believes that this will occur due to latent vulnerabilities to supply chain breakdowns, geopolitical tensions and the effects of climate change, and the Fed not wanting to see any relapses of inflation at 2022 levels. “We are in a world much more susceptible to supply shocks than the one we left,” Shkodina said.
As for what the rate cuts will look like concretely, some see economic growth eclipsing inflation as the Fed’s priority. “If the data in spring 2024 points to growth becoming the greater concern over inflation, we see the Fed starting to cut rates from the second quarter of 2024 onward, with the funds rate gradually falling to 4.50 percent to 4.75 percent by year-end,” stated Craig Leibowitz, senior director of Market Intelligence at Avison Young.
Despite the seemingly gloomy near-term outlook, most commercial real estate assets stand to benefit in the long run, once some form of long-term stability is established. With this in mind, Rockey sees deal velocity picking up in the second half of 2024. “(CRE) can transact in high-rate environments, so as soon as there is stability in the rate outlook, I think we will have a more meaningful uptick,” she said.
As for the assets that will perform the best in the coming years, most, including office, appear to be poised for long-term gains. “Even on the office front, the vast majority of vacancy is in a very small subset of the market,” Jodka said.
Rockey agrees, and believes that well-located, high-quality office assets, as well as assets having undergone restructuring, such as industrial, data centers and life science facilities will make for “great investments.”
“It’s an interesting time to be a real estate investor,” Jodka concluded.