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  • Writer's pictureRealFacts Editorial Team

The Pros and Cons of a Strong Economy for CRE

Commercial real estate properties

In commercial real estate (CRE), the interplay between various market dynamics often yields mixed outcomes. What benefits one sector might disadvantage another, and trends that buoy certain regions can simultaneously undermine others. This intricate dance is particularly evident in the current strong economic environment. While robust market conditions have boosted rents and occupancy rates, they have also contributed to the Federal Reserve's reluctance to reverse its stringent monetary policy—a change desperately needed to rejuvenate transaction volumes.

Graph of volatile net exports

Macroeconomic Dynamics

The first quarter of 2024 saw inflation-adjusted GDP growth at an estimated 1.6% annualized, a notable decrease from late last year but still within long-term averages. However, the real story lies in the shifting contributions to GDP growth. Net export data, frequently revised, dragged down aggregate GDP, primarily due to a significant rise in imports from Q4 of the previous year—a clear indicator of an economy far from faltering.

Graph of interest as a percent of GDP

Despite these challenges, personal consumption expenditures remain robust, and household debt service payments are not consuming an above-average portion of disposable income. Credit card delinquencies have spiked recently but are still well below long-term averages, indicating that the economy can handle additional pressure in this area.

The Labor Market's Resilience

The labor market continues to exhibit strength, with a tight job market ensuring steady employment, wage growth, and robust consumer spending. This dynamic supports businesses, spurring production and growth, which in turn sustains the demand for labor. Although there have been anecdotal reports of layoffs, particularly in the tech sector, the overall labor market sentiment remains positive, with quits still outnumbering layoffs. This suggests that many layoffs are driven by goals of margin expansion and efficiency rather than revenue decline.

Geopolitical and Fiscal Concerns

According to Thomas LaSalvia, head of CRE economics, the primary economic risks today stem from geopolitical distress rather than fundamental domestic supply and demand issues. However, the growing level of government debt is a concern for both the long-term economy and the immediate real estate market. Federal debt as a percentage of GDP now stands at approximately 120%, and the real issue is the cost of debt servicing. As the government spends more on servicing its debt, it has less to invest in crucial areas like infrastructure and education, putting additional pressure on interest rates as more Treasuries are sold.

Interest Rate Projections

Graph of interest rate projections

Moody’s projects a higher, longer-run neutral interest rate. While the Federal Reserve could cut rates by up to 50 basis points this year and continue cuts next year, likely, 4% 10-year Treasuries and 6-10% real estate financing rates will become the new normal for some time.

CRE Specifics

Graph of urban market momentum

The demand for CRE has generally remained moderately strong, preventing significant stress across most sectors. However, the office sector continues to struggle, with the national vacancy rate climbing to a record 19.8% in Q1. Employee attendance has improved but peak days still only see 60-80% attendance. This sector is expected to face another 18-24 months of weak performance as it seeks stability. Nevertheless, some metros like Nashville, Wichita, and Miami, along with specific suburban submarkets, have shown notable improvements in leased space and effective revenue growth.

Sector Performances

The retail sector experienced modest rent growth and flat vacancy rates in the first quarter, with positive absorption trends continuing for the thirteenth straight quarter. Industrial performance, however, showed some weakness due to low financing and speculative leasing and construction during the early pandemic days. Effective rent growth has declined for three straight quarters, and vacancies are at their highest in two years, part of the sector's cyclical nature. The self-storage sector has also felt pressure, with occupancies dipping at the start of 2024 but expected to rebound slightly as summer approaches.

Housing Market Dynamics

Graph of income needed to avoid rent burden

In the housing market, vacancies for market-rate apartments remained flat nationally in the first quarter, with mildly negative effective rent growth. Strong inventory growth and demand kept occupancy at 94.5%, driven by factors such as a rebound in international migration, steady employment and income growth, and high mortgage rates that keep potential buyers in the rental market. However, the gap between asking and effective rents has widened significantly, indicating increased concessions due to excessive Class A inventory growth.

Affordable Housing Trends

Affordable housing markets, particularly in the Western and Northeastern regions, remained competitive with low vacancies and long wait lists. Nationally, vacancies for LIHTC markets rose slightly but are expected to decrease by year-end, similar to levels seen in late 2023.

Graph of core property type sales volume year-over-year

Capital Markets: Signs of Life

After seven consecutive quarters of declining activity, the CRE capital markets show signs of recovery. Larger assets in gateway markets are beginning to attract cautious investors and lenders focusing on high-quality assets. This uptick is partly due to the much-needed stability in interest rates, which has eased underwriting and reduced bid-ask spreads.

Future Outlook

Despite the emerging stability, challenges remain. Lending is still restricted, office sectors are distressed, and smaller transaction volumes lag behind pre-pandemic levels. However, improvements in lending activity and stabilization in rates, transactions, and lending suggest a path forward.

Moody’s CRE economists expect conditions to get somewhat worse before they improve, especially with upcoming CMBS office loan maturities posing significant challenges. While we are on a path to recovery, there is still a long way to go. For a more detailed analysis, watch the replay of the Q1 2024 Quarterly Economic Briefing and read the April Maturity Monitor for insights into CMBS office loan maturities.


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