Investment sales volumes of commercial properties have been on a slow-but-steady decline since the Federal Reserve began increasing interest rates 18 months ago, but that doesn’t mean that investors aren’t eager to deploy capital in the face of falling prices and valuations.
As interest rates have steadily risen, so too have capitalization rates, and commercial buyers that rely heavily on debt to fund purchases have been forced to scale back on new acquisitions. With fewer offers, sellers have seen their prices drop off from two years ago, when assets in classes like multifamily and industrial experienced record levels of rent growth, price appreciation and cap-rate compression.
Yet it remains unclear just how close to the bottom the market actually is, or whether the nadir of pricing and deal volume has already been reached. What is clear is that in downtimes such as these, investors of all types are looking for opportunities to “buy the dip.” Particularly for choice assets, enduring some interest-rate-induced pain in the short run is a fair trade-off for gaining a long-term foothold in high-growth markets — and at a premium price, no less.
The disconnect between demand and deployment was detailed in the Emerging Trends in Real Estate 2024, an annual report jointly produced by PricewaterhouseCoopers and the Urban Land Institute (ULI). The report includes proprietary data and insights from more than 2,000 commercial real estate industry experts, gathered through a survey and in-person interviews.
The report gauges market sentiment via a “barometer” that explores how investors feel about buying, selling or holding in the current environment. The barometer for 2024 registered its highest “buy” rating since 2010. According to the report’s authors, this finding indicates that the investment community has seen and continues to see declines in pricing. Consequently, there are opportunities to buy at discounts following a decade in which values rose and cap rates compressed for most commercial assets. The high “buy” rating for 2024 suggests that investors expect these conditions to hold for much of the new year.
More specifically, industry professionals who responded to report surveys said that while they generally expected inflation to subside in 2024, encouraging the Federal Reserve to pause rate hikes, most do not expect interest rates to decline significantly next year. Or as one respondent stated: “The good news is that we have more clarity [and] more certainty, but the bad news is we don’t like what we see because rates will be higher for longer.”
Should these circumstances materialize, it stands to reason that deal volume will remain sluggish in 2024 while “dry powder” — capital that is earmarked for immediate deployment when conditions change — continues to build up on the sideline.
“Many investors, especially ‘core’ institutional funds, remain on the sidelines, waiting for the right entry point when prices will fall enough to make returns compelling,” the report’s authors wrote. “But that might take a while because few owners face enough distress to force inopportune sales. And most investors are looking for the end of interest rate hikes, which seems close at hand, though the wait for actual rate cuts will take longer.”
“Many in our industry see a negative loop wherein buyers and sellers cannot agree on pricing because the shortage of sales limits price clarity,” the report’s authors continued. “There is no doubt that wide bid-ask spreads between buyer offers and seller expectations are limiting transactions.”
As previously noted, the report’s authors and survey participants have yet to see a major uptick in the inventory of product for sale via forced dispositions from owners whose loans are nearing maturity. Yet, for some of these owners, refinancing at current interest rates will simply be financially implausible, potentially boosting the amount of product for sale over the course of the next year.
“Owners facing major lease or debt expirations may be forced to sell, particularly if the higher debt costs render refinancing unfeasible or the asset cannot satisfy required loan terms or covenants,” the report noted.
The immediate future is murky
The magnitude of the impacts of 11 interest rate hikes totaling 500-plus basis points in 18 months is hard to overstate.
Some investors have been able to circumvent interest rates and keep buying by tapping into cash reserves, leveraging existing equity partnerships or assuming the seller’s existing loan. But for most investment groups, the burgeoning cost of capital is an inhibitor that cannot be worked around. It’s a stark reminder of the absolutely crucial role that lending plays in commercial real estate investment and development.
As a result, investors are expressing greater concern over their bottom lines, as evidenced by feedback from survey participants. While roughly 40 percent of survey respondents rated their firm’s 2024 profit outlook as good to excellent, that is the lowest share since the Emerging Trends report from 2011, when the industry was rebounding from the Global Financial Crisis of 2008. Meanwhile, 13 percent of respondents rate their firm’s profit outlook as abysmal or poor, the highest such proportion to select that option in over a decade.
The expression “survive ’til ’25” — a reference to the common belief that true relief from the stranglehold of interest rate hikes is still more than 12 months away — seems particularly apropos in light of this finding. As the report noted, outside of the office sector, fundamentals remain relatively healthy for most major commercial asset classes. But the fallout in the debt markets was severe enough that it will take time for a reset to occur. Until then, many major investment groups, especially institutional players, will remain sidelined.
— Taylor Williams