Lower interest rates and the Fed's signal that it plans to further cut its target for the Federal Funds rate 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 real estate deals easier to finance, helping to accelerate price discovery and increase value. However, the rate cut of 50 basis points is too modest to solve all the existing issues of the sector.
“The rate hike 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 hikes over the past few years have been quite substantial.”
of The public real estate market serves as the main indicator for the sector as a whole and has been the price in the anticipated reduction of rates for some timenoted 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 have a positive impact on the broader real estate universe.
This is important because there has been a persistent gap between the public and private real estate markets in recent years. In the rising rate environment, public REITs fell 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 valuation-based indices, never recorded that kind of decline. As of the third quarter of 2022, the difference between the cap rate for private real estate, according to NFI-ODCE indexand the implied FTSE Nareit All Equity REIT Equity Index peaked at 244 basis points, according to the Nareit analysis. The gap emerged in part because public REIT valuations change daily with market fluctuations, while the estimated cap rate for private real estate is determined quarterly and tends to move gradually. As of mid-2024, the gap between the two benchmark rate measures had narrowed to 120 basis points, driven in part by the recovery in public markets and continued adjustments in private valuations, which have fallen for seven straight quarters. Now, with the normalization of interest rates, this gap may narrow further.
“Going back to the third quarter of 2022, the implied REIT rate was at 6.07%, and the private valuation cap rate was 3.63%,” said Edward F. Pierzak, senior vice president of research at Nareit , in an interview earlier this year. . “Fast forward to today, the implied REIT rate through the first quarter was 5.8%, and the private equity rate was 4.6%. So on one hand you can see that the implied REIT rate has been somewhat stable in its pricing, while the private equity rate has increased by over 100 basis points.
The rise in REIT prices since then is likely to contribute to further closing the gap, although the extent to which will not be clear until the end of the third quarter, when the next ODCE index reading is released.
The fact that debt costs should decrease, making it easier for investors with expired debt to refinance, should also play a role in stabilizing the public and private real estate markets.
“Commercial real estate is essentially a leveraged 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 quite significantly for the better part of 2 1/2 years. “said Hill. “So the U.S. commercial real estate market is enjoying falling interest rates because it's a welcome relief valve.”
Cohen & Steers predicts that prices in the private real estate sector will hit a low in the next quarter or two, helped by lower rates and sellers' acceptance of declining valuations over the past two years.
Jim Gott, senior director and head of asset oversight EMEA for commercial real estate with Mount Street, a global credit servicing firm, also said lower interest rates will help accelerate price discovery and strengthen the interest of investors in this sector.
An indication of the recent aversion of retail investors to private real estate is evident in decline in investment in non-traded REITs through 2024. As of the end of July, fundraising for non-traded REITs totaled $3.4 billion, according to Robert A. Stanger & Co. This is a significant decrease from 2023 ($10.2 billion for the full year) and 2022 ($33.2 billion).
“With real estate investors focused on both the market fundamentals of the property-level space and the cost of capital, the rate cut attributed to eroding inflation concerns will be welcomed by investors and constructive for the valuation of property,” wrote John Berg, global head of private real estate. property with investment management firm Principal Asset Management. Berg warned, however, that if the rate cut is accompanied by rising unemployment and concerns about broader economic performance, this could 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 was unchanged from last year, showing no significant change in prices. At the same time, investment sales volume fell in every sector, ranging from a 14% drop in senior housing to a 27% drop in retail sales. However, the figures marked an improvement in the sector as they signaled a leveling off from the decline in deal volume and prices starting 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 may have had difficulty securing a loan previously, according to Ross Yustein, chairman of the real estate department. with Kleinberg Kaplan, a New York City. – based law firm. The promise of additional cuts in the coming months could also reassure lenders that they can extend loans to distressed properties in the hope that the extra time will help landlords improve performance, he noted.
However, at 50 basis points, the cut is still too small to be a “magic bullet” for concern in the commercial real estate sector, Yustein warned.
Similarly, Hill noted that the recovery in commercial real estate during this cycle is likely not to follow the broad V-shaped pattern that occurred after the Great Financial Crisis because global central banks are not providing stimulus money.
“We think we're near the bottom, and we think this is going to be kind of the old recovery in commercial real estate, driven by fundamental growth,” he said.