For two years now, the U.S. commercial real estate market has been all dressed up with nowhere to go. Fundamentals have weathered a surge in rates and new supply impressively well, but increased financing costs continue to undermine deal activity. Despite continued dormancy, we see causes for cautious optimism that the market is forming a trough. The most important effect of higher rates may now be their suppression of construction activity, which will reduce supply in the coming years, a potential game-changer for property incomes.
Key takeaways
- The CRE market continues to be constrained by higher interest rates. The decline in property values has slowed due to healthy fundamentals, but a bid-ask spread remains.
- CRE debt spreads have tightened, as sign of improving investor sentiment.
- There is a growing recognition that higher rates are suppressing construction activity, which will likely lead to undersupply and higher rent growth over the next few years.
More than two years after the Federal Reserve began its campaign to bring inflation back to its 2% target, the U.S. CRE market remains in the throes of a correction. Market activity stayed muted in the first half of 2024 as financing costs continue to thwart potential buyers. As we discussed last quarter, optimism is growing among market participants that the market is in the process of troughing, though the shape and timing of any recovery is highly uncertain. We think the second half of the year could finally present signs of thawing in the frozen transaction market, especially given the strong recovery in CMBS issuance during the first half.1
Our primary rationale for cautious optimism stems from our view on CRE fundamentals. Property incomes have held up reasonably well throughout this correction, even as elevated new construction has pushed vacancy rates higher in some sectors. Due to the unique nature of this cycle and the (somewhat) counterintuitive impacts of monetary policy, CRE fundamentals could be in for a reacceleration in the coming years. While this forecast horizon may seem outside the purview of a quarterly outlook, we believe it could catalyze improvement in investment activity sooner as investors come to digest these dynamics.
Demand for space, while having decelerated from historic levels, remains robust in most property sectors. Net absorption—which measures the amount of space newly leased net of space vacated—is significantly positive in three of the four major sectors. Multifamily, in particular, has seen a sharp improvement in the demand picture over the past year, while the industrial sector has found a more sustainable level. Retail has continued to act as the unsung hero of the CRE asset class, and even malls posted positive absorption and a dip in vacancy in the most recent quarter.2
Perceptive readers will note vacancy rates have gradually risen in most sectors, with the lone exception being retail. While demand has been strong, the uptick of new completions has been more formidable, especially in the sought-after multifamily and industrial sectors. The U.S. has seen 612,000 new apartment units delivered over the past four quarters, a 36% increase from full-year 2022. Within industrial, 515 million square feet have been delivered, a 29% uptick from 2022.2
For the most part, this represents a rational market response to an unusually tight environment. Construction activity stalled at the onset of the pandemic, as most experts predicted a long, drawn-out recession. As the economy recovered unexpectedly quickly, demand for housing and industrial assets soared while few new properties were being completed to meet it. The result was predictable: Vacancies plunged and rent growth surged to a peak of over 10% in early 2022, a record for both sectors. Developers then raced to capitalize on a historically tight market by breaking ground on a record number of new projects in 2021 and 2022—the same buildings that have been completed over the past year.2
All signs point to this building boom being a brief one. Construction conditions have changed markedly over the past two years; rent growth has mostly normalized, but more importantly, financing costs have risen sharply. This has led to a significant decline in construction starts: Groundbreakings for both multifamily and industrial assets have fallen back to levels last seen in the early 2010s, representing a dramatic round-trip over the past three years. Construction activity in the retail and office sectors is also subdued, but for different reasons. Retail building peaked in the mid-2010s and never recovered due to the “retail apocalypse” narrative, while office construction has plunged more recently as the property type has faced its own existential reckoning. In all, aggregate construction starts among the four major property types hit a decade low in Q4 of last year.2
The result of this seems straightforward but its importance should not be understated. Underbuilding today results in a paucity of new available space in the coming years. In the multifamily sector, for example, CoStar forecasts completions to plunge beginning in the second half of this year and trough in late 2026 at a level last seen in the aftermath of the Global Financial Crisis. There appears to be no easy remedy for this slow-motion supply crunch: Rates figure to come down only gradually (if at all), meaning the challenging financing environment is likely to persist. Even if rates did fall tomorrow and spur new activity, the lead times involved in construction today would still leave a supply gap in the coming years.2
With a supply gap in the coming years now near unavoidable, a continuation of the solid CRE demand environment would likely result in a retightening of property markets. Vacancy rates would likely fall and rent growth would be pushed higher. In this way, the Federal Reserve’s policy over the past two-and-a-half years—designed to bring demand in line with supply in the short-term—stands to create another disequilibrium in the medium term by challenging the production of new property. This is further complicated by the fact that inflation measures such as the Consumer Price Index (CPI) incorporate a measure of shelter costs that lags trends in the rental market by a year or more (read more about this in our Q3 Macro outlook).
If this is expected to take place over a multiyear time horizon, why are we discussing it at such length today? We believe this dynamic—and its increasing recognition among market participants—will drive two key trends in the near term.
- Increasing confidence around fundamentals could lead to a pickup in market activity.
As we have discussed, the rise in interest rates over the past two years coincided with a bevy of new construction supply hitting the market in many sectors. While resilient demand has kept fundamentals afloat, the one-two punch of rates and supply has been a challenging one for the market to digest. To the extent investors gain increasing confidence that new supply is drying up while demand for space stays strong, this could be the catalyst needed to push transaction activity higher—even if interest rates do not decline. - Higher rent growth could mean higher-for-longer interest rates.
It is no secret that soaring rents have contributed substantially to inflation since mid-2021. This is clearest in the residential market, where rent and owners’ equivalent rent have sourced about half of the increase in CPI since 2022, but it can be applied across many sectors.3 Higher rental costs for warehouses and retail spaces raise costs for business, which are most often borne by end-consumers. If the CRE market retightens as we expect, rents could return as an inflationary force and ultimately keep interest rates higher than they otherwise may have been.
