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Commercial real estate investors, owners and occupiers all have been monitoring whether the Federal Reserve will impose interest-rate cuts in 2024 after rapidly rising rates have substantially increased the cost of doing business.

Earlier this month, the Fed signaled it needed to see more progress toward its inflation target of 2% and decided to maintain its key lending rate. At that meeting, Fed Chairman Jerome Powell said gaining greater confidence around inflation “will take longer than previously expected,” although he also said he felt inflation would move back down in 2024.

For executives in commercial real estate, waiting for those rate cuts may prolong the uncertainty being felt in the market today.

Mark Roberts, managing director of research at Dallas-based real estate investment and development firm Crow Holdings, said the underpinnings of why the Fed hasn’t cut interest rates — a strong economy and labor market — are actually good fundamentals for commercial real estate.

He added that for many buyers and sellers of real estate, a reset to the new rate environment has already begun, noting that values are down on average 22% in the past seven quarters. That’s unlocked some deal momentum, but cumulative transaction volume in the first quarter of this year was still at its lowest level since 2013, according to Altus Group. It estimated $31.6 billion transacted across major property types in the U.S. in the first three months of the year, down 28% compared to the same quarter last year.

“The other side of the coin is, what does it mean for those who utilize a lot of leverage in their investments?” Roberts said. “For leveraged buyers, it’s not necessarily the best time, and that’s why a lot of dry powder is stacking up.”

Others in commercial real estate echoed that sentiment, saying there’s a lot of capital sitting on the sidelines that hasn’t yet been deployed — waiting, in large part, for more certainty in the broader U.S. economy.

At the end of 2023, when the 10-year Treasury rate had dropped to below 4% and borrowing rates began to stabilize, there was a greater sense of optimism that that capital raised would be put to work sometime this year, said Andrew Alperstein, partner at PricewaterhouseCoopers LLP’s financial markets and real estate group. But a stronger-than-expected economy this spring has dampened some of the optimism around any forthcoming rate cuts.

Still, even if cuts were to occur later or are more modest than previously expected, Alperstein said most real estate principals have accepted that a sub-3% environment isn’t coming back anytime soon and have begun re-pricing within the new market conditions.

“There’s a reality that has set in that rates are going to be at least moderately higher for a period of time, and investors will hopefully move forward on that premise,” Alperstein said. “What we’ve also seen is that sellers have not really been wanting to sell unless they had to. Folks have been watching closely for evidence of distress sales and forced sales — and yes, we’ve seen some, but not as many as people probably thought. We’ve got an interesting couple of quarters ahead.”

Buyers right now are generally motivated because of equity that’s available, Alperstein said. And more borrowers may be forced to make decisions on their CRE-backed loans if a higher-than-longer rate environment persists.

But more deals in general will mean broader confidence in the market on what the new norm is in returns and values, Alperstein said.

“That will hopefully be a positive thing,” he said. “I think we hoped we’d get this sooner, but some of the uncertainty around rate cuts and the increase in the 10-year [Treasury rate] has slowed that progress.”

Ripple effect on leasing decisions

Although a delay in interest-rate cuts arguably has the most direct impact on commercial real estate buying and selling, it’s also factoring into how companies think about their real estate leasing decisions.

Rob Kane, senior executive vice president and co-leader of Dallas-based Lincoln Property Co.’s corporate advisory and solutions group, said the cost of capital and interest rates ripple through most every significant decision among the occupiers with which his firm works.

“If rates are higher for longer, it means continued uncertainty around decision making,” Kane said. “Internally, it means their business is more expensive to run, and I think we’re seeing, in certain cases, a lot of focus on capital containment and preservation. It’s very difficult for a [chief financial officer] to make a long-term decision when they have uncertainty around long-term rates.”

The past four years have been marked by uncertainty around real estate decisions by companies large and small, with many opting to sign short-term renewals as they figure out how much space they need in a post-pandemic world that embraces hybrid work. Some of that uncertainty has begun to ease, with a greater number of office tenants signing longer deals and relocating to newer towers, but a higher-for-longer rate environment may mean other companies will continue to prolong more-permanent space decisions.

It’s become common for companies to take less square footage in higher-quality office buildings, Kane said. He added that while some tenants will opt to delay their decision-making in an effort to cull spending during a higher-for-longer market, others will try to seize opportunity now.

“There are a significant number of companies … that will be able to make decisions and are going through the process to take advantage of the volatility to trade into higher-quality assets,” Kane said. “I think you’re going to continue to see that playing out across the country.”

That, in turn, will have wide-ranging effects on lenders and owners, Kane said, including accelerating the amount of distress facing lower-quality properties, which tenants are leaving in favor of newer buildings.

Impact on new construction

Since the Fed began increasing interest rates in 2022, new construction across major commercial real estate sectors has slowed.

Industrial construction starts dropped for the sixth consecutive quarter, to less than 40 million square feet breaking ground in Q1. For 2024, CBRE Group Inc. previously forecast that multifamily starts would fall by 45% this year from their pre-pandemic average and by 70% from their 2022 peak.

Office, the most challenged commercial real estate sector, has seen new-construction groundbreakings decline for five consecutive quarters, according to Jones Lang LaSalle Inc. In Q1, JLL recorded less than 300,000 square feet of office construction starts, the lowest total in nearly 40 years of data.

As the cost of financing remains higher than where it’s been recently, and traditional CRE lenders remain more tepid in their lending to the sector, that’ll continue to dampen the future pipeline for most property types, including traditionally hot ones like multifamily and industrial.

“The returns that developers need to target are just not going to be achievable with the cost of financing and the cost of construction and the availability of financing,” Alperstein said. “As we look out 24 months, there’s going to be a window of time there where there will be very little new supply hitting the market, and that will most likely be positive for the fundamentals of multifamily, industrial and even some retail.”

Roberts said persistently higher interest rates will mean the next real estate cycle will shift into a new equilibrium in supply and demand, where structural occupancy rates will be higher than where they’ve been in recent years,

In industrial real estate, for example, the long-term occupancy rate in the past 20 years has hovered about 93%, but the long-term average will start to move higher, closer to 97%, Roberts said. That overall is a good thing, to sustain the warehouse market’s investment environment, he added.

Some owners and developers will continue to turn to new or alternative financing mechanisms to get deals done — including new construction, experts say.

“There is capital out there for creative financing,” said Brent Maier, real estate advisory leader at Baker Tilly. “It comes down to relationships and the appetite for cost. If you go to a nontraditional lender, sometimes that money can be more expensive, but if you have a good asset or a good deal, it generally pencils out if it is attractive.”


Source:  SFBJ

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Federal Reserve Chair Jerome Powell said Thursday he expects to see some banks fail due to their exposure to the commercial real estate sector, which has declined significantly in value following the shift to remote work.

Powell said the banks that are in trouble with falling office space and retail assets are not the big banks, which were designated as “systemically important” in the aftermath of the 2008 financial crisis. That episode, which resulted in a taxpayer bailout of the financial sector, was also triggered by unsound real estate assets.

Rather, the banks at risk of failure now Powell identified as smaller and medium-sized.

“This is a problem we’ll be working on for years more, I’m sure. There will be bank failures,” he said during a Thursday hearing on the Fed’s monetary policy in the Senate Banking Committee.

“It’s not a first-order issue for any of the very large banks. It’s more smaller and medium-sized banks that have these issues. We’re working with them. We’re getting through it. I think it’s manageable, is the word I would use,” he said.

Powell didn’t go into detail about the specific regulatory actions regarding commercial real estate exposure that are now being undertaken by the Fed, which is both the federal currency issuer and one of the primary bank supervising agencies, though he did say he had identified the banks most at risk.

“We are in dialogue with them: Do you have your arms around this problem? Do you have enough capital? Do you have enough liquidity? Do you have a plan? You’re going to take losses here — are you being truthful with yourself and with your owners?” he said.

Commercial real estate investment trusts, known as REITs, have taken a hit over the past few months. Alexandria Real Estate Equities, Boston Properties, Kilroy Realty Corp., and Vornado Realty trust are all in negative territory since the beginning of the year.

Powell described the decline in value of commercial real estate as a result of remote work following the economic shutdowns of the pandemic as a “secular change” in the economy.

“In many cities, the downtown office district is very underpopulated. There are empty buildings in many major and minor cities. It also means that all the retail that was there to serve those thousands and thousands of people who work in those buildings, they’re under pressure, too,” he said. 

While the decline of commercial real estate values could put some banks out of business, Powell expressed confidence that the Fed and financial regulators would be able to contain the fallout and prevent a broader crisis. Thirty-four U.S. banks have failed since 2015, according to the Federal Deposit Insurance Corp. (FDIC), which insures deposits at regulated banks.


Source:  The Hill

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As they say, if you don’t want the answer, don’t ask the question. But Congress did insist that Federal Reserve Chair Jerome Powell talk about the economy and the Fed’s take this morning. His testimony is probably not what most people want to hear, but certainly what businesspeople, especially in CRE, need to.

If, like an economic Dylan Thomas, you were concerned that the Fed’s policies might go gentle into that good night, don’t worry, they aren’t.

In the testimony, Powell quickly invoked the Fed’s dual mandate of promoting maximum employment and stable prices. Notice, there is no direct mention of easing business costs or supporting asset prices. Those are supposed to come as byproducts — boost business to indirectly promote employment and slow it to moderate prices.

“We have covered a lot of ground, and the full effects of our tightening so far are yet to be felt,” Powell said, for those who want a pause to assess progress. “Even so, we have more work to do. Our policy actions are guided by our dual mandate to promote maximum employment and stable prices. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of labor market conditions that benefit all.”


Or, as Oxford Economics translated in an emailed note: “Fed Chair Jerome Powell used his semi-annual testimony to push back against financial markets as his comments were hawkish, noting that the terminal rate for the fed funds rate could be higher than previously anticipated. He noted that he isn’t hesitant to increase the pace of rate hikes if the data on employment and inflation continue to come in stronger than anticipated.”

Although inflation had seemed to be slowing, January was a jarring reminder that inexorable progress toward goals is unusual. Jobs, consumer spending, manufacturing numbers, and inflation “reversed the softening trends that we had seen in the data just a month ago.”

It was the “breadth of the reversal” that meant inflation was running hotter than during the last meeting of the Fed’s Federal Open Market Committee. And even then, the underlying message was not to expect immediate lower interest rates.

Inflation “remains well above the FOMC’s longer-run objective of 2 percent,” and Powell was talking not just the overall number, in which housing costs were a major driver. He specifically mentioned core personal consumption expenditures (PCE) inflation without the volatility of food and energy that push upwards, and core services without housing, which discounts that outlier.

“Although nominal wage gains have slowed somewhat in recent months, they remain above what is consistent with 2 percent inflation and current trends in productivity,” said Powell. “Strong wage growth is good for workers but only if it is not eroded by inflation.”


Then he got to interest rates. “We continue to anticipate that ongoing increases in the target range for the federal funds rate will be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time. In addition, we are continuing the process of significantly reducing the size of our balance sheet.”

So, continuation of maybe 25-basis point increases and also continued scaling down of the balance sheet, which means reducing purchases of bonds that help fuel home mortgages and, so, that entire part of the construction and sales ecosystem.

However, the maybe is not to be ignored.

“While a quarter-point increase in the Federal Funds rate is still the most likely outcome of the Federal Reserve’s March meeting, expect the Fed to adopt a half-point increase in March if data on inflation and labor conditions continue to run hotter than expected,” said Marty Green, a principal with mortgage law firm, Polunsky Beitel Green, in an emailed note.


Source:  GlobeSt.