Commercial real estate faces new financing landscape

The U.S. economy proved resilient following a sluggish close to 2023. At its final meeting last year, the Federal Reserve signaled rate cuts of at least 75 basis points in 2024, which will likely provide conditions for the U.S. Treasury yield curve to normalize.

But will rate cuts be enough to bring stability to commercial real estate (CRE) valuations and increase transaction volume? Only time will tell; however, a wave of refinancings set to come due over the next few years, a sustained higher cost of capital, and the need for increased equity investment will present challenges and potential opportunities for the industry.

Impact on cap rates if the 10-Year Treasury normalizes

Now, with inflation receding and the economy operating at nearly full employment, the Fed has signaled its intention to lower its policy rate, which RSM projects will target 4.6% this year, 3.6% next year and 2.5% over the longer term. As the central bank shifts to a less restrictive monetary policy, RSM expects the yield curve to normalize in 2024, moving to a range of 4% to 4.25%. That would mark an approximate 100 basis point increase from 3.13% at the end of the second quarter of 2022, when the CRE market came to a sudden halt.

Transaction volume in 2023 was 31% lower than in 2022, according to CoStar data, as the CRE market continued to navigate fluctuating valuations. However, the 10-year Treasury yield signals where investors’ risk premium will price commercial real estate. According to CBRE, historical data suggests that a 100 basis point increase in the 10-year Treasury results in a 60 basis point rise in capitalization rates. The average U.S. national index cap rates for retail real estate ended 2023 up 52 basis points compared to the second quarter of 2022, while office was up 71 basis points over the same time period. These increases may be a hopeful sign that we are close to closing the gap between buyer and seller pricing in these core sectors. Quality is proving to hold strong, as Class A office properties saw only a 40 basis point increase in cap rates for the same period.

However, multifamily and industrial—both red-hot sectors in the post-pandemic period—may now experience further compression. According to CoStar data, multifamily cap rates rose 121 basis points since the second quarter of 2022. The sector ended 2023 with an average cap rate of 6.8%, in line with 6.6% at the close of 2019, directly ahead of the pandemic; this indicates multifamily is now resetting from temporarily low cap rates. The industrial sector, by comparison, has seen a rise of only 27 basis points during the same period, attributable to strong fundamentals from inflated cash flows and demand for last-mile logistics centers. We are likely to see further cap rate increases in certain industrial markets and subsectors as inflation eases and tenant leases turn over.

While increasing stability in both monetary policy and yields will help ease the cost of borrowing, costs will remain high, keeping cap rates elevated despite further drops expected in the 10-year Treasury yield through 2026. A larger spread between long-term yields and CRE cap rates will draw investors back into all commercial sectors as their risk appetite returns and likely boost transaction volume beginning in the second half of 2024 following interest rate cuts. However, compression of valuations poses a greater concern for owners looking to refinance and avoid distressed asset sales.

Commercial debt maturities

Falling 10-year yields over the four decades preceding the pandemic created conditions for CRE to borrow and refinance at lower rates upon debt maturity, reducing costs at every refinance period. The rapid rate increases since 2022 have changed the sector’s dynamics, creating much more challenging conditions for properties with debt coming due.

Commercial properties have approximately $5.82 trillion in outstanding debt, of which $2.8 trillion is scheduled to mature in the next five years, according to Trepp data. These maturing loans will generally face higher interest rates than at origination, as debt yields have doubled since early 2022, compressing returns. Lower-performing assets, which include much of the outdated office space across the country and in metro areas with lower return-to-office rates, may not be able to refinance or bear the higher cost of capital.

Private debt market

Private debt is well positioned to continue expansion during the structural shift in lending: Investors seek diversification in capital positions within CRE to protect the equity downside risk as cap rates rise. The yields on gap funding, such as mezzanine loans and preferred equity, come at a price as institutional investors seek returns of 10% on private debt, according to Preqin’s June 2023 survey. Still, borrowers have been more receptive to securing additional financing to execute riskier plays in this market. Doing so also brings flexibility in structuring, increases the certainty of funding and builds a long-term relationship for future deals.

Mezzanine fundraising was a standout in 2023, with $40.6 billion raised as of the third quarter of 2023 compared to 26.2 billion in the full year of 2022, Preqin data shows. Mezzanine positions come with higher returns than direct lending, but also carry additional risk due to their subordinate position in the capital stack. While $536.90 billion of debt matured in 2023, delinquencies for most asset classes, excluding office, remained relatively low and stable over the trailing 12-month period ending December 2023.

Not surprisingly, the commercial office sector had the highest year-over-year increase in delinquencies, jumping to 5.82% in December 2023 from 1.58% in December 2022. In the near term, we expect to see more delinquencies as office debt continues to come due; however, we are optimistic this trend will level off amid increased clarity around property valuations and longer-term corporate plans for office expansion. Some 46% of middle market executives plan to increase their organization’s number of physical workspaces over the next two years, according to data from the Q4 2023 RSM US Middle Market Business Index survey.

The takeaway

As the market continues to adjust to higher borrowing costs and compressed valuations in the face of significant maturing debt, we are certain to see the basics of real estate return. Location and asset class will play a major role for institutional investors seeking quality assets that will hold their value. Hotel, retail, industrial and storage properties have been standouts for banks due to their solid fundamentals and less volatile underwriting. But as returns decline in core sectors, niche assets such as data centers, senior housing, storage and suburban single-family rentals will be attractive areas for private debt and opportunistic equity investment.