The prevailing theme from economists and commercial real estate research teams is that the outlook for the coming year is “better” than the last. Forecasts are calling for positive, albeit slower, economic growth and lower interest rates, and fears of a recession seem to be fading.
“I don’t think the Fed has overshot. I think the economy is a lot more resilient than the average person perceives,” said BGO chief economist and head of U.S. research Ryan Severino. Barring any idiosyncratic disruption, the economy appears to be on course to keep chugging along, he added.
However, there are still challenges ahead for capital markets. “Volatility will be a feature of the market in 2024, certainly early in the year, but we do expect things to be trending more positively,” said CBRE vice president of capital markets research Darin Mellott. One of the big wild cards in 2023 was how high rates would rise. Now, there seems to be conviction that rates have hit a peak and will move lower in the coming year.
Based on Federal Reserve meeting minutes released in December, some Fed members expected the federal funds rate to fall to 4.6% by the end of 2024, suggesting that the Fed would cut rates by 75 basis points this year.
“It’s really a function of the lower interest rates that is driving our relative optimism, and I use that word ‘relative’ carefully because we’re not talking about a gangbusters year,” said Mellott. The fact that the 10-year came down to a sub-4% level in December also gave the market a boost in confidence with more potential for upside in industry forecasts. “In 2023, we were constantly evaluating all of the downsides. That’s not to say the downside risk doesn’t exist anymore, but it’s plausible that you can see things being even a little bit better than we anticipate,” he said.
CBRE forecasts that the 10-year Treasury rate will drift lower this year to settle around 3.5% by year-end. That rate is still noticeably higher than where rates were throughout the pandemic and in the decade following the global financial crisis of 2007 to 2009. In 2019, the 10-year Treasury averaged 1.8%. Interest rates are not likely to go back to those exceptionally low levels, at least not anytime soon. “We do expect them to come in enough that it’s going to be supportive of commercial real estate activity and values,” said Mellott.
Yet opinions are mixed on the timing of rate cuts from the Fed. Some are hopeful that reductions could come as early as March. Severino expects the Fed to be hesitant for the first couple of months to make sure that the decline in inflation is entrenched. “If the economy slows the way that I think it will, then I do think there is a higher probability for rate cuts in the latter half of the year than in the first half,” he said.
Experts agree that it’s difficult to predict what action the Fed will take. “It’s all data dependent, and right now, there’s a lot of questions swirling about the timing and the amount of rate cuts in what will be prudent,” said Trepp director of research Stephen Buschbom. However, the market is already baking in expectations for rate cuts. After hitting a high of 4.98% in October, the 10-year Treasury dropped more than 100 basis points in December and hit 4.19% as of this morning.
The drop already has stimulated transaction activity. “It was nice to see an atypical increase in transaction volume and deal volume going into the end of the year, which is usually pretty quiet,” he said. “To me, that said there’s a lot of pent-up activity on the sidelines that will continue to stay involved so long as the longer end of the curve is pricing in those rate cuts.”
On the negative side, the market is still dealing with tighter liquidity and a wave of maturing loans that need to be refinanced at higher rates and with more equity requirements. In addition, slower economic growth could impact demand for commercial real estate.
One of the biggest risks to the economy in 2024 could be a stall in disinflationary trends and stubbornly high inflation, prompting the Fed to keep rates higher for longer. “That’s not our base case,” said Mellott. “We think that inflation is going to continue to trend downward, and we think that the Fed’s preferred measure will be pretty much at target by the end of the year.”
Another risk for the economy is that performance might not live up to expectations. “To be clear, it’s not like I think it’s going to be Shangri-La and we’re going to party like it’s 1999 or anything,” said Severino. “But I think the economy is going to hold up better than people expect, and real estate markets will probably hold up better than people expect, with some pockets of dislocation.” Still, consensus has swung hard toward the soft-landing narrative, and if there are bumps in the road, people might end up being disappointed, he added.
Ratings agencies continue to wave the caution flag on potentially deteriorating credit. Fitch Ratings is one that predicts deteriorating credit trends for commercial real estate loans in 2024. S&P Global also highlighted challenges and risks in its Industry Credit Outlook 2024: Real Estate. The firm expects higher-for-longer interest rates to continue at least through mid-2024. In addition, slowing economic growth, higher unemployment and weaker job growth are likely to put pressure on occupancies and operating income, while asset values could move lower.
On a positive note, overall loan delinquencies likely have hit a peak. According to Trepp, commercial mortgage-backed securities delinquencies for all property types averaged 4.51% in December, down 7 basis points from the prior month. Retail CMBS delinquencies have experienced a bigger decline, dropping from 6.97% in December 2022 to 6.47% in December 2023. Many of the problem loans on the retail side were large regional malls, and many of those have worked through the system, either through liquidation or through modification, noted Buschbom. “As we continue to see them exit the system through liquidation or through modification and refinance, I think we’ll continue to see that delinquency rate come in lower,” he said.
Lower capital costs would give transaction markets a needed boost. According to MSCI Real Assets, transaction volume for 2023 through November was down 55% to $323.8 billion. Retail property sales declined 39% to $52.1 billion.
“Whenever the Fed stops raising rates, commercial real estate returns have reverted back into positive territory pretty quickly,” said Severino. Even looking at how the data unfolded in 2023, investors got less negative over time as the year progressed. Investors will still be a little bit tentative in the first couple of quarters this year, but unless something unexpected happens, it likely will be a better year for both transaction volume pricing and returns than since the market started to sour in the second half of 2022, he noted.
What really has caused volume to pull back and investors to be tentative has been high interest rates and not economic fundamentals and real estate market fundamentals. “I don’t want to be misleading and say this is going to be an amazing environment, but I do think that we are on the path to things being better,” said Severino. Improvement in 2024 likely will gain more traction in 2025.
From the pickup in transaction volume that occurred in December, it definitely felt like there was a breakthrough of a resistance point, added Buschbom. “If funding costs drop below a certain level, you do see parties move off the sideline and start to transact a lot more frequently,” he said. That tipping point could be a roughly 4% rate on the 10-year Treasury rate. “It’s still extremely costly to transact, but that 4% seems to be a level of which everybody’s kind of gotten comfortable underwriting around,” he said. It also is important to note that not all deals underwrite at that level. It’s a more palatable level for lower-leverage deals, whereas the value-add market is still relatively frozen, he added.
Lower interest rates are going to help deals get done, and there is still a lot of capital on the sidelines that investors want to deploy. “It’s not going to be a linear process of recovery, but we do think that the overall trends this year are positive for commercial real estate, and that includes on the financing end,” said Mellott.
Retail also is in a solid position. Because new construction virtually shut off, there has been very little new supply over the past 10 years and retail fundamentals have improved considerably. “I think capital is going to be relatively comfortable going after the right retail assets because of that,” said Mellott.
CBRE’s house view is that transaction volume will increase 5% over last year, more of that occurring in the second half of the year. This year is not going to be a big year by any means, but there will be more stabilization, and there is room for potential upside scenarios where sales could exceed 5% growth, noted Mellott. Overall, 2024 could be a bit of a transition year. “It’s not going to be linear,” he added. “There’s going to be lots of volatility and different things that challenge us along the way, but we expect the overall year to trend more positively and set us up for a strong 2025, as well.”
By Beth Mattson-Teig
Contributor, Commerce + Communities Today