By: Head of Data Strategy at LightBox, Manus Clancy
U.S. investors got a pleasant surprise in mid-September when the Fed opted for a 50-basis point (bps) rate cut instead of 25 bps—which was what many market analysts were predicting.
The move was unprecedented. Never before had the Fed cut by more than 25 basis points absent huge market turmoil, as during the Great Financial Crisis. With U.S. housing prices at or near all-time highs in many markets and with the major U.S. stock indexes circling near all-time highs, the U.S. financial markets were anything but tumultuous.
Yes, the U.S. unemployment rate had been moving higher and many U.S. retailers issued warnings during Q2 earning season. But the lack of any meaningful volatility is September and with equity markets near their peaks, investors were left thinking: “What does the Fed know that we don’t know?”
To be sure, the big cut doesn’t come without a significant measure of risk to the Fed. Lower rates mean lower borrowing costs, which could mean another leg up in housing prices. That could eventually reverse the 24-month decline in CPI. It could also whet investors’ appetites to put more “risk on.” If the move leads to more market froth, the Fed could end up regretful.
Clear Win for the Commercial Real Estate Market
While the 50-bps cut was a bit of a gamble for the Fed, it was an unmitigated “win” for the commercial real estate (CRE) market. Let us count the ways.
For borrowers that acquired properties using floating rate debt in 2021 or early 2022, relief is here. Floating rate debt is typically tied to the Secured Overnight Financing Rate (SOFR), which is a benchmark interest rate reflecting the cost of borrowing cash overnight using U.S. Treasury securities as collateral, plus a spread (or margin). As SOFR rose from near 0% to over 5% in 2023, many borrowers saw their debt service costs double.
The rise in interest rates wiped out free cashflow from many properties, causing the debt service coverage ratio (DSCR) to drop significantly. A strong DSCR is typically above 1.50x, meaning the property generates enough income to cover debt payments with a buffer. However, for many properties in this elevated-interest rate environment, the DSCR fell below 1.0x, meaning they no longer generated enough income to meet debt obligations. As a result, there was a significant increase in delinquent loans, particularly in the CRE collateralized loan obligation (CLO) sector.
The rate cut will provide those borrowers with some immediate, albeit modest, relief. (Amen!) The markets are also expecting more rate cuts over the next 18 months which would add to that relief.
The expectation of a rate cut, and a slowing of the U.S. economy has helped drag interest rates at the long end of the curve lower for the last few months. The yield on the 10-year Treasury peaked at around 5% several months ago. As of late September, the yield on that bond was below 3.80%. This resulted in lower borrowing costs for those needing to refinance and reduced cap rates for those hoping for enough loan proceeds to pay off existing debt.
Those impacts should help CRE default rates level off in the near future. (That is, except for office). More on that below.
Lastly, the rate cut should give the CRE market a nice psychological boost. Property owners have been eagerly awaiting a firm up of property values. Falling rates have given them that. Prospective buyers have been itching to deploy capital. A rate cut may spur buyers to move before prices firm up any further.
And Then There’s Office…
While signs were quite positive in general for the CRE market in September, the office market—for the most part—will not benefit from the recent rate cut or drop in long-term Treasury yields.
Properties in many major U.S. markets are selling for 60% to 80% below the most recent sales prices for those same assets five to 10 years ago. There will probably be many more unfavorable comps like this over the next year.
That being said, there is a silver lining, even to these dismal sales comps. The one thing worse that bad comps is no comps at all. In fully illiquid markets, likes ones that existed in 1991 and 2008, very little transacted. The markets were frozen, and no distressed assets could be resolved.
Currently, assets are trading. That should allow a bottom to form and distressed assets to “clear.” The fact that none of the sizable losses on office loans has led to a hiccup for a large lender thus far can be seen as a positive for the lending market overall.
On the leasing front, there were some positives and negatives.
In Portland, Oregon, U.S. Bank announced it will not be renewing its lease at Big Pink skyscraper. The bank currently leases approximately 222,000 square feet inside the tower, formally called U.S. Bancorp Tower. That is a tough pill to swallow in that market.
However, big leases by IBM in Austin—taking over 320,000-square feet from Meta’s department at The Domain; OpenAI in San Francisco—signing the city’s biggest office deal of the year; and a big loan extension and refinancing on the Schwab Tower debt on a 417,000-square-foot, 17-story building in San Francisco shows that there are some bright spots here and there.
In addition, it was reported that 701 Brickell in Miami is under contract to sell for $450 million or $655 per square foot. Elliott Investment Management is acquiring the property from Nuveen.
Other Bright Spots
Multifamily:
- FPA paid unconfirmed $221 million for a nearly 700-unit apartment in Waltham, MA.
- Fairfield Residential paid $120 million for a 476-unit property in east Denver.
- Longacre Management acquired a 24-property NYC portfolio for $180 million.
Industrial:
- Investcorp paid $300 million for a three-property portfolio spanning 1.4 million square feet.
- MCB Real Estate paid almost $70 million for a vacant property in Freehold, NJ.
The Last Word
We remain modestly optimistic about the CRE market for Q4.
No one expected the melt up we saw in 2021, but sales activity should continue to improve, and distress should level off as lower rates bring a modicum of relief by way of lower borrowing costs and higher property values.
Stay tuned.
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