What happened?
On Wednesday, September 18, 2024, the Federal Open Market Committee (FOMC)—the body charged with deciding on and implementing monetary policy—voted to lower the federal funds rate by 50 basis points (bps) to a target range of 4.75% to 5%. The 50-bps magnitude cut was in line with market expectations as of this morning, which underscores that the Fed executed this milestone first cut without measurably surprising markets or expectations in the near-term. Both the magnitude of the cut, along with the tone of Powell’s press conference, signal that the Fed is willing to take decisive yet measured action in balancing both sides of its mandate.
Updated projections from the FOMC suggest that the Fed will cut rates by another roughly 50 bps through year-end (bringing target rates to the low-to-mid 4% range by year end 2024) while also cutting roughly 100 bps through 2025 (bringing target policy rates to the low-to-mid 3% range by the end of 2025). Effectively then, based on where neutral policy rates are expected to be, the Fed is projecting that it will be finished or near-finished with its rate cutting cycle by early 2026.
Regardless of the magnitude of the cut today, the forward guidance provided by the Fed is very helpful in providing the markets with a better indication of the magnitude of cuts moving forward, which helps deliver some certainty to investors on the rate outlook for the near-term. The Fed will also continue to maintain the current pace of quantitative tightening, allowing an average of $60 billion in Treasurys and mortgage-backed securities to roll off its balance sheet each month.
What does it mean for commercial real estate?
- Despite the cut, monetary policy remains restrictive to economic growth. The neutral rate where Fed policy is neither holding back nor stimulating growth is widely believed to be between 2.5% and 3%. Although the Fed funds rate has now been reduced by 50 bps, it still remains upwards of 175-200 bps above the neutral rate, which will continue to dampen economic growth and therefore demand for CRE space from its potential.
- Historically, however, when the Fed starts cutting rates, it signals better days for financial market liquidity conditions, business conditions and ultimately net operating income (NOI) growth. Today’s rate cut means policy has become slightly less restrictive, which is a step toward more supportive financial conditions for the economy and movement closer to more neutral monetary policy, which are both positive influences for CRE fundamentals, cash flows and underwriting assumptions.
- Dry powder to start moving off the sidelines. Today’s cut may also help move some of the mountain of dry powder ($382 billion globally as of September) off the sidelines as it signals CRE is at the cusp of the next growth cycle.
- Today’s rate cut means the Secured Overnight Financing Rate (SOFR) will also come down 50 bps. Assuming that risk spreads over the base rate remain steady, floating rate debt just became less expensive. At the margin, this will help some borrowers get certain deals across the finish line and help others with existing floating-rate debt stave off debt service challenges.
- The 10-year treasury is expected to stay in the 3.75% – 4.25% range. The financial markets anticipated this rate cut and had already priced it in, along with future cuts. The 10-year treasury yield has already captured these expected rate movements. We expect the 10-year treasury to hover in the 3.75% - 4.25% range, consistent with potential nominal GDP growth believed to be around 4%. As investors grow accustomed to normalized interest rates, financial markets become more stable, boosting confidence and stabilizing risk premiums and credit spreads. Tighter and more stable spreads translate to more fluid debt and capital markets.
- Fixed rate debt costs have improved, helping to restore neutral-to-positive leverage conditions versus cap rates. CRE conventional fixed mortgage rates have already dropped 50-100 bps since peaking in October of 2023. In terms of spreads, fixed rate debt is now pricing at roughly 175 bps-250 bps over Treasurys—on par with historical averages. In addition to lower overall debt costs, this contraction in base rates helps the financial engineering of CRE deals by restoring some neutral or positive leverage conditions for fixed-rate product relative to cap rates. Floating rate debt, which links to SOFR, is still pricing in the 7-7.5% range, (though it is likely to come down after the rate cut). We will likely need a few more rate cuts before floating rate debt is closer to neutral and eventually back into positive leverage territory.
- Cap rates spreads are also nearing the strike zone. To compensate for risk, cap rates are typically 250-350 bps over risk-free Treasurys; today, these spreads for office and retail are near or slightly above these levels and are improving for industrial and multifamily. Higher spreads over risk-free rates make CRE comparatively more attractive, which helps to draw more buyer interest and tips the proverbial scales of the capital markets toward ongoing traction and recovery.
Green Shoots
We are observing numerous green shoots that lead us to believe the CRE capital markets are nearing an inflection point. Most notably:
- The year-over-year (YOY) declines in sales volumes have stabilized. In 2023, sales volumes were down 50% YOY. In the first quarter, sales volumes were down 12% YOY. Second quarter 2024 volumes, meanwhile, registered a 3.5% YOY improvement. Despite the fact they are likely to remain choppy through year-end, they are clearly trending toward growth.
- REITs are rebounding. REIT stock prices typically lead private sector pricing because REITS are traded daily, offering transparency and a high-frequency lens into investor sentiment. They typically lead private CRE by 9-12 months—not always, but usually. Since last October, the All-Equity REIT index is up 30%, while Office is up 39%.
- Banks are easing lending standards. According to the latest Fed Senior Loan Officer Opinion Q2 2024 survey, a rising share of banks are reporting they are loosening lending standards and seeing stronger demand for CRE loans.
- CMBS is firing back up. YTD Non-Agency CMBS issuance is up 160% through Q2 2024 vs. a year ago. Meanwhile, YTD conduit CMBS issuance is measuring at $20 billion, which has already surpassed the full-year conduit issuance level for 2023. For additional perspective, 12-month rolling average issuance levels (measuring at over $76 billion) are on track with where they were in early 2022, before the rate hiking cycle unfolded. Broadly speaking, CMBS is an important source of debt liquidity for CRE, particularly at a time when Banks are working on bolstering their reserves and evaluating their CRE portfolio concentrations and exposures.
