Don't Expect A Deal Surge: Interest Rate Improvements Will Take Time To Trickle Down

With interest rates holding steady and cuts seeming likely in the new year, falling yields for the 10-year Treasury and inflation that seems to have finally been brought to heel, the U.S. property investment market looks more promising than it has for over a year.

Still, damage was done over the last 18 months, and even though the CRE industry rejoiced on last week’s indication from the Federal Reserve that lower interest rates are probably in the offing in 2024, the return of regular, profitable transactions will take some patience.

“I'm not sure investment activity is going to come immediately in the new year, but there's a general sense that it will pick up and that when it does, it will turn on pretty quickly,” Hodes Weill & Associates Managing Partner Doug Weill said.

The Federal Open Market Committee’s announcement that rates would stay the same until at least the end of January when it meets again — and that the majority of its members favor a drop in rates next year — had immediate positive effects in the market. Stocks rallied, and Treasury yields continued their downward trajectory from recent months, dipping below 4% for the first time since August.

But before property markets can begin to reap the rewards of an improved financial picture, there are some hurdles to overcome. The wide canyon separating the expectations of buyers and sellers is high on the list, Weill said.

Buyers and sellers have struggled to come to terms on the value of assets all year, with some sellers looking for prices more like those they saw in the lucrative days of 2021. In many cases, they need the highest offer possible to cover debt service or improve their liquidity positions.

Meanwhile, the buyers most likely to be active in today’s market are those seeking deals. The two strategies just don’t align, and it will take time for the two sides to come back together.

“The private markets are slow to react,” PTM Partners CEO Michael Tillman said. “It just takes time for this stuff to work itself out in the private markets, and it's always lagging the public markets. I think there'll be a rising volume, but as a result, there will need to be a price adjustment. There's only so long that the banks can hold value when loans start to come to maturity.”

Price discovery will be key across property types, Weill said. To reach that point, any given market will have to see enough transactions to set new baselines for important pricing metrics like cap or discount rates, he said.

“The one hurdle, though, is the debt market,” Weill said. “Spreads are still pretty wide, and that makes it hard if you're transacting with leverage, which is most buyers.”

Getting financing is likely to remain difficult even if rates tick down as banks repair the damage to their own books and deal with potential new regulations in the wake of 2023 bank failures.

The demand will be there for loans, LH Meier economist Derek Tang said.

“The issue is whether banks and other financial institutions are going to meet that demand,” Tang said. “The financing environment for banks is still tight, and there's a lot of uncertainty about how the banking situation is really going to shake out.”

Regulators including the Fed and the Federal Deposit Insurance Corp. in July proposed a new set of capital requirements for banks, a long-awaited suggestion that gained prominence in the wake of the collapse of Silicon Valley Bank and Signature Bank in March. The reforms would require banks with $100M or more in assets to increase their capital reserves by at least 16%. A public comment period initially scheduled to end in November was extended to Jan. 16.

“That is going to weigh on sentiment, and banks are probably going to be still quite conservative with their loan books while looking for opportunities that are kind of a sure thing,” Tang said.

Then there’s the fact that the distress that has developed in the market won’t simply disappear because the interest rate picture has improved.

“There's been distress, and we believe we will continue to see the distress in the system, primarily in the office market,” PwC partner Tim Bodner said. “But not anything close to what we saw during the [Global] Financial Crisis. We've never believed that. We still don't believe it. Now we feel very good that the Fed is expected to do 150 basis points of cuts, starting as early as March.”

Distress is reflected in recent delinquency rates for CRE. Commercial real estate loan delinquency increased 21 basis points during the third quarter to 1.03%, according to S&P Global Market Intelligence. That was the largest quarter-over-quarter increase in at least five years, pushing the delinquency rate above its early pandemic high of 1.02% in Q4 2020.

Decreasing rates are certainly a positive development, and the trend should have a stimulating effect on sales volume in the industry and make apartment construction easier, National Multifamily Housing Council Senior Director, Research Chris Bruen said, though for multifamily, the data lags a few months. So outside of anecdotal evidence, it will be difficult to know exactly what kind of bounce the market is seeing from lower Treasurys and a lower cost of lending.

“Rates are still high, and the economy is still digesting the interest rate hikes that have already taken place,” Bruen said. “So there's still risks to the broader economy. It's yet to be seen what exactly the magnitude of this positive will be.”