As interest rates decline following the Federal Reserve's recent cuts, many investors in commercial real estate are watching closely, wondering how these moves will affect the market. Historically, it takes anywhere from 1 ½ to 3 ½ years for commercial property sales volume and prices to begin rising after interest rate cuts, but this timeline isn't set in stone. The eventual outcome will depend on how aggressively the Fed continues to reduce rates, and whether they return to the historically low levels we've seen in recent years. In this article, we’ll explore how the current rate environment might impact commercial real estate, from borrowing costs to property values, cap rates, and distressed sales.
Commercial Real Estate and Interest Rates: A Delicate Balance
Commercial real estate is deeply intertwined with borrowing costs. Typically, investors purchase or refinance properties with loans that mature in 10 years. From 2014 through the second quarter of 2022, these loans were issued during a period of extraordinarily low interest rates—below 2.5%. Now, with rates significantly higher, around 6.2% as of August 2024, those loans maturing today were financed at just 4.3%, a jump of nearly 200 basis points. The steep increase in borrowing costs has led many investors to adopt a wait-and-see approach, hoping that rates will drop further before they act.
The Federal Reserve's recent half-percentage-point cut is an encouraging sign for investors, but rates remain elevated compared to the pre-pandemic era. Industry professionals, including analysts at S&P Global, suggest that rate changes will likely be modest, and we may not see a return to pre-pandemic commercial interest rates anytime soon.
The Past as a Guide: What History Tells Us
Looking back at historical trends offers some clues about what we might expect. Commercial real estate sales volumes tend to rise when the federal funds rate falls below 2.6%. When the rate exceeds 5%, as it did in 2023, sales often decline. For instance, between the third quarter of 2006 and the second quarter of 2007, the federal funds rate remained above 5%. Sales volumes fell sharply during this period and didn’t recover until the first quarter of 2010—after 10 consecutive quarters of decline.
The current situation bears some similarities. The federal funds rate once again surpassed 5% in mid-2023, and sales volumes have since been sluggish. If history is any guide, it may take until late 2025 or early 2026 before we see a significant uptick in transaction activity. However, now that rates are beginning to fall, investors who have been holding off may finally feel more confident about buying, selling, or refinancing.
Price Trends: The Long Road to Recovery
Price per square foot or unit is another key metric to consider. Historically, property prices hit their lowest point four to five years after the federal funds rate last exceeded 5%. It also took that long for prices to start rising again once the Fed began cutting rates. While price movements can vary by asset type and location, it's clear that investors should not expect an immediate price rebound following rate cuts. Instead, the recovery will likely be gradual, with prices potentially beginning to rise around 2026.
For investors, this means that there may be opportunities to acquire properties at a discount in the near future, especially if you're willing to hold the asset through a longer recovery period. Properties in prime locations or sectors that have been hit particularly hard by the current high-rate environment—such as office buildings—could be available at attractive prices.
Cap Rates and Valuation
Cap rates are a fundamental valuation metric in real estate. They estimate a property’s potential return on investment and are influenced by interest rates. Lower cap rates typically indicate a lower-risk, more valuable property, while higher cap rates suggest more risk but also higher potential returns.
Historically, cap rates start climbing about five quarters after the federal funds rate exceeds 5%, and they continue to rise for about two years after the Fed starts cutting rates. This trend is expected to repeat in the current cycle. As borrowing costs remain high, cap rates have been rising, which could lead to lower property valuations in the near term. However, as rates decline, cap rates should eventually stabilize or even decrease, enhancing property values.
For investors, understanding the cap rate trend is crucial. While rising cap rates could lead to attractive investment opportunities, they also reflect the higher risk and lower property values that come with an elevated interest rate environment. Timing is key, and those who invest during the early stages of the rate cuts could benefit from both rising cap rates and, later, rising property values.
Distressed Sales and Mortgage Delinquencies
The rising interest rate environment has also contributed to an increase in distressed sales and mortgage delinquencies. When borrowing costs increase, property owners who financed their assets during the low-rate period may struggle to meet their debt obligations, leading to distressed sales. Historically, the percentage of distressed sales accelerates within three years of the federal funds rate exceeding 2.5%. Given that the rate has been above this level since 2022, we are likely entering a period where distressed sales will rise, providing potential buying opportunities for investors.
Similarly, commercial mortgage-backed securities (CMBS) delinquencies tend to rise when borrowing costs increase. The last time the federal funds rate exceeded 5%, CMBS delinquencies began climbing just two quarters later, and it took six years for the delinquency rate to peak. In the current cycle, CMBS delinquencies started rising one year after the Fed began increasing rates in early 2022. Fitch Ratings forecasts that the delinquency rate will continue to rise through 2025, though it may not surpass the peak seen during the last cycle.
Vacancy Rates and Market Health
Vacancy rates are another important indicator of market health. During the last period when the federal funds rate exceeded 5%, vacancy rates for office, industrial, and retail properties peaked about three to 3 ½ years later. This pattern is likely to repeat, meaning we could see vacancy rates continue to rise for some time.
The office sector has been particularly hard-hit, with vacancy rates already rising as a result of both the pandemic and the subsequent increase in interest rates. While other sectors, such as industrial and multifamily, have fared better, all property types could see some softening as higher borrowing costs put pressure on landlords and tenants alike.
Preparing for What’s Next
For investors in commercial real estate, the recent rate cuts are a welcome signal that relief may be on the horizon. However, as history shows, the effects of lower interest rates on the market won’t be immediate. It will take time for borrowing costs to come down, property prices to stabilize, and sales volumes to increase. In the meantime, those who are patient and strategic may find significant opportunities, whether through acquiring distressed assets, capitalizing on rising cap rates, or locking in lower borrowing costs as rates continue to fall.
The key is to stay informed and be ready to act when the right opportunities arise. While the road ahead may be bumpy, the long-term outlook for commercial real estate remains positive. Investors who understand the trends and act accordingly will be well-positioned to succeed in this evolving market.
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