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September 12, 2024 • An Analysis by Carrie Taschman via moody’s

The Commercial Real Estate (CRE) industry has been anxiously awaiting action from Jerome Powell and the Federal Reserve for several quarters now. Even though the industry has largely begun to emerge from its most recent lows, the first rate cut is crucial to recovery. The question remains, however: will these cuts be enough to get the CRE market back up to speed?

Macroeconomic Factors

Before diving into the CRE specifics, let’s zoom out and take a look at the macroeconomy. Despite some small stock market blips, fundamentals are fairly strong for the time being.

Employment is “full”, but with some nuance

Figure 1: Noncyclical rate of unemployment estimated at 4.4%

Even with a recent increase, the US unemployment rate remains below 4.4% – the number that the congressional budget office estimates for noncyclical unemployment. However, we can’t dismiss the recent increase. The current three-month average unemployment rate and the lowest three-month average rate over the past few years has exceeded .5%. This means that the Sahm rule is triggered. Economist Claudia Sahm has found that when this difference hits .5%, it suggests that we are on the brink of a recession or may have already entered one. This has held up in most previous situations, but the difference here is in labor demand. Unlike past downturns, current job openings are still reasonably high, and labor supply has been increasing. With this in mind, Moody’s economists are not adding a recession into the baseline forecast at this time.

What will the Fed’s rate cut look like?

Given a tight (but weakening) labor market, fairly stable prices and moderate interest rates, we expect the Fed to slowly begin reducing the rate starting this month. However, we don’t anticipate a dramatic decline back to the rates of the pre-COVID era. Due to current economic and demographic fundamentals, Head of CRE Economics, Thomas LaSalvia, predicts “a new interest rate regime with rates mores similar to the 90s and early 2000s” for the foreseeable future. Moody’s economists expect major CRE demand drivers, like household formation, income, and employment growth to hold up well, but expect the more volatile corporate profit growth to decline after strong recent performance.

Figure 2: Moody’s rate forecasts

For complete article including office market information, click here…

Retail shows strength in neighborhood and community shopping centers

Alongside a persistent preference for e-commerce, certain types of brick-and-mortar retail have exhibited comparative strength. Neighborhood and community shopping centers have posted relatively flat vacancy rates over the past three quarters and moderately positive effective rent growth. Despite consumer confidence reading at an eight-month low, retail sales exceed expectation and will likely be boosted by fourth quarter holiday spending.

For more insights on retail, read economist Nick Villa’s Mid-Year Retail Performance Review.

Market conditions for the multifamily sector

The swell in apartment construction has begun to play out in the multifamily sector, which closed out the first half of 2024 at 5.7% vacancy. This surpasses the pandemic peak from the start of 2021 and is about 40 basis points higher than the 20-year average. Because of the supply shock, this number isn’t too concerning, especially given strong fundamentals in the form of rising household formation and lowered single-family transactions. Asking and effective rent turned positive as of Q2 after two quarters of decline, and 60% of the 275 Moody’s CRE markets recorded positive rent growth in Q2, as opposed to only 40% in Q1 of this year. After a short rollercoaster ride for the sector over the past four years, this current period is one of stabilization.

Effective revenue suffered a 1.6% decline year-over-year

As the apartment market continues to settle into its stable state, effective revenue has dropped 1.6% from the double-digit effective rent growth that we saw during the expansion stage of the cycle. Operating expense increases and elevated loan payments have put a strain on net cash flow for apartment owners. Despite headlines pointing fingers at insurance premium hikes, recent research shows that payroll and benefits, utilities, and repair and maintenance are largely responsible for driving up total operating expenses in the multifamily sector. Even so, multifamily effective rent growth continues to beat the CPI index in the longer term.

Metros in sunbelt states (like the Carolinas) which were largely considered to be winners in the pandemic, have lately experienced elevated vacancy and revenue losses. Many apartment projects broke ground in these areas, chasing rent growth during the expansion stage of the cycle. However, as these projects come online, demographic patterns are already normalizing and frictional oversupply has pushed vacancy up. Metros in the so-called Snowbelt (New York, Pennsylvania, Ohio, Michigan, Indiana, Wisconsin) initially trailed the Sunbelt in terms of demand, but have now caught up and are leading rent growth.

Figure 6: Snowbelt Rent Growth Outpaced Sunbelt

Speaking of migration, much of this has been driven by job opportunities and/or housing affordability. You can read more about housing affordability trends and changing patterns in rent burden in this quarter’s housing affordability update.  

Figure 7: Vacancy and Rent Growth Forecast

Economist Lu Chen expects that the last part of the construction boom will be covered by population growth – particularly, international immigration. We’ll likely see reduced deliveries soon, and the number of housing permits and starts have receded from their peak. Given the time needed to absorb the oversupply, Moody’s CRE economists expect that national average vacancy will likely move up to 5.8% by the end of 2024 before retreating. As supply dwindles and demand steadies, rent will likely grow.

Capital Markets

Entering the “pre-recovery” stage

Last quarter finally brought about some good news for commercial real estate capital markets, and we’ve entered what Head of CRE Capital Markets, Kevin Fagan, refers to as a “Pre-Recovery” stage. Basically, a bottom has finally begun to form – even for office. The typical downturn of a CRE capital market cycle involves transaction volume slowing, a lending pullback, value declines, and credit worsening. The lending pullback ended in Q1 of this year after six quarters and trading volume has gone positive after seven quarters of decline. For value declines, the data is starting to show some flattening and price discovery. We’re likely to see a little more decline as the dust continues to settle, and credit will likely worsen due to additional value declines.

As we see in Figure 8, year-over-year transaction for the core four sectors is positive for the first time in two years, and retraction is slowly beginning to decelerate. This recovery is much slower than 2021’s historical rebound off COVID, but this is a more normal pace for recovery. The $64 billion in transactions we saw in Q2 is quite small when compared to a more normal year, which might see $100 billion per quarter, but we’re 9% off the bottom, and moving in the right direction.

Figure 8: Core Property Type Sales Volume Year-Over-Year Growth

Industrial, office, and hotel were all positive in Q2 of this year (though office comes off a very low basis). Retail remained fairly flat, but the real lag in volume change by property type is multifamily. This isn’t surprising given this sector has the tightest cap rate risk premium of these asset types.

Looking at size, large sales drastically decreased early in this cycle, as expected. Lenders felt wary of taking on large loans when the Fed started hiking rates. However, large loans are leading us back out of the contraction – a combo of capitulations, transactions to lock in gains, and just normal transaction volume finally sneaking back in.

The CRE debt supply and demand gap is tightening

Via the MBA origination index, volumes for lenders are slightly up, reaching 3% year-over-year in Q2. This improvement was led by CMBS, which is doing well, but off a very low basis, as CMBS took the hardest hit when the Fed started raising rates. CMBS made a big comeback, with 155% year-over-year growth in Q2. Private lenders and LifeCos are also positive, but banks continue to struggle. However, this retraction is going in the right direction, and we expect banks to start lending more, potentially reaching positive by the end of 2024. Lending supply and demand are finally converging, and year-over-year growth in lending volume should follow soon.

Figure 9: Gap between supply and demand for CRE debt tightening

For more detail on the Moody’s CRE economists’ outlook, watch the replay of our latest Quarterly Economic Briefing, where experts add nuanced insights and cover additional topics, including: self-storage performance, affordable housing, senior housing, student housing, valuations, delinquencies, and more.

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Carrie Taschman is an Assistant Director at Moody’s, specializing in commercial real estate, macroeconomics, and financial education content. She holds a bachelor’s in Economics and English from the University of Rochester. 

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The data points presented in this article are sourced from the Moody’s CRE dataset, unless otherwise stated. This dataset includes property, market, sub-market, and regional statistics. For more information on the dataset, visit https://cre.moodysanalytics.com/capabilities/data/.