The Federal Reserve's inaction in the first half of 2024 has left many commercial real estate investors scratching their heads. While hopes for the first interest rate cut in over four years haven't been dashed, a disjointed investment sector remains, prolonging the waiting game for improved deal economics and boosted valuation expectations.
David Evans, senior associate in the Los Angeles office of Kidder Mathews, the largest fully independent commercial real estate firm in the Western US, describes the gap between buyers and sellers as "a moat." Adds debt & equity specialist Jorge Gomez, VP in the Los Angeles office: "Buyers and sellers continue to face a valuation gap, while lenders operate more conservatively and selectively and thus are not able to fill the gap the way they did when rates were a few percentage points lower."
Options Down So Effort Must Be Up
What should the CRE sector do now? Seller financing with existing loans that have at least two years left on the term is an attractive option, says David Evans, a senior associate at Kidder Mathews in LA. Meanwhile, Gomez notes the tool is mutually beneficial to buyers and sellers, allowing sellers to better reach their target price and buyers to use in place of long-term financing while waiting for rates to settle.
Distressed real estate should offer more buying opportunities, with savvy investors capitalizing on significant discounts after loan defaults and foreclosures, says Kidder Mathews' debt & equity specialist Jim Henderson, SVP, in San Francisco. Many existing high-leverage loans at low rates will require cash for refinancing, which Henderson sees as an opportunity for a buyer to come in and make a deal if unmet.
Overall, the continuing capital environment will require all parties to be more proactive: Sellers should actively engage with the market, and buyers should update their valuation models to account for higher rates while getting lenders involved early in the process. Absent any monetary easing, buyers and sellers need to find a way to be more aligned on expectations, asserts Kidder Mathews Chairman & CEO Bill Frame.
Outlook
Deal volume is picking up for engaging buyers and sellers willing to meet the market, Evans says. Frame adds that investors should start underwriting deals of interest given that "we are closer to lowering rates than increasing them."
Gomez reminds that the Fed treats CRE as tangential to the greater risk of inflation. Commercial property debt, which is in far better shape than its residential counterpart before the Great Recession, remains in the central bank's "peripheral vision."
"They will not cut rates until they are near certain that inflation will meet their 2% annual target in the foreseeable future though the latest CPI inflation data certainly bolsters the argument for a cut," he says. "CRE debt issuance has been disciplined through the cycle and, except for office loans and late-cycle high leverage, floating-rate bridge loans, lender positions remain safe with sufficient equity to keep borrowers engaged with their properties."
That relative capital stability, combined with still-strong fundamentals, should mean a healthy rebound in deal volume when rate cuts do eventually come. Every Kidder Mathews expert pointed to multifamily to lead the way given the persistent housing shortage in many parts of the country, with Gomez maintaining that "value-add and construction deals should get back to business as usual." Frame adds that warehouses and Class A offices will also be asset types to watch in the new cycle.
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Brian A. Lee
Brian A. Lee is an Atlanta-based freelance writer and former editor of Western Real Estate Business magazine. The Wake Forest and University of Georgia graduate has covered commercial real estate since 2000.
