In an industry that hasn’t felt “normal” since the pandemic, it feels like every year we work to try and figure out how COVID-19 and its ensuing impacts on the economy and interest rate policy will affect the CRE market. At Aline Capital we are watching three specific trends, all somewhat correlated, that we think will be driving factors for the CRE market in 2025.
After peaking in 2021 at $877B, commercial real estate transactions maintained record-high levels in 2022 of $771B, before dropping off a cliff (-51%) in 2023 to $378B. While not finalized, a mild recovery of just over 9% ensued in 2024 to $413B. The expectation as reported by Urban Land Institute’s Real Estate Economic is for a much stronger recovery of just over 33% from 2024 to $550B in 2025.
Deep interest rate cuts spurred by the pandemic provided extremely inexpensive capital for CRE transactions in 2021 and 2022. This also allowed for peak valuations among assets, prompting many owners to become sellers with very low barriers for buyers given the low interest rate environment. Reversing course to fight inflation, the very quick run-up in interest rates by the Federal Reserve was the primary driver for the drop in transaction activity in 2023, as borrowing costs created a bid-ask spread between buyers and sellers that became insurmountable. In addition to that, an overall liquidity squeeze from traditional lenders and strain on the banking sector made a difficult problem even harder.
In 2023 the challenges was as much the pace at which rates increased as their ultimate resting place. While there was little to no expectation for rate increases in 2024, stubborn inflation data staved off the expectation for rate cuts, which were expected to show up much earlier in the year. This created significant volatility in the treasury markets and ultimately higher than expected interest rates for CRE Borrowers. 2024 began the year with a 10-year treasury just under 4.0%, but it quickly rose to its peak of 4.7% by the end of April, leaving many borrowers without good refinance options and also a basis above potential sales prices.
While a record number of loan maturities in 2024 should have driven more transaction volume, many investors were unwilling to accept where current values were given the dramatic drop in values from 2022 – 2024. Owners were between a rock and a hard place unwilling to sell without great options for refinance. Given the expectation that rate cuts were eminent and hopefully coming soon, many lenders allowed borrowers to extend their late 2023 maturities into 2024 with little skin off their back. When that same wall of maturities came in late 2024, the lending market had not improved remotely close to the level needed for investors to gain the proceeds they needed to refinance. While market pricing had stabilized and somewhat improved, many sellers still did not like the prospects of selling. Instead of dolling out loan extensions with little to no repercussions again in 2024, lenders began really demanding a pound of flesh for extensions, or providing extremely short extensions demanding payoffs, forcing some transaction activity.
The market faces a similar issue with another record level of maturities in 2025, even before considering the loans that got short extensions from 2024 into 2025. With $998B in loan maturities and no material improvement in borrowing options, lenders in 2025 will not be offering friendly extension options and many owners will be forced to sell. This will increase transaction activity independent of any favorable moves by interest rates.
In addition to forced sales, the market has had some time to absorb the movements in values and interest rates, and substantial demand and liquidity has built up in the acquisition space. While the industry faced some short-term challenges in 2023 and 2024, CRE has garnered the interest of the institutional and international investor market again. With the recent drop in values, many investors like the prospect of acquiring deals well below their peak values, while getting many of the benefits that CRE investment provides.
Overall, tough love from some lenders coupled with substantial demand and liquidity in a market that has garnered some price discovery will be major factors that drive CRE transactions in 2025.
September 2024 marked the Fed’s first interest rate cut, followed by two additional cuts for the rest of the year, resulting in a total 1.00% cut to the fed funds rate from its peak. While the expectation is for additional cuts to the fed funds rate, this has had varying impacts on the treasury market, which is ultimately the source of fixed interest rates for CRE. In fact, the very day that the Fed made their first interest rate cut, the 10-year treasury increased slightly intra-day. A major part of this is the normalization of the yield curve, which is when longer-dated bonds have higher yields than their shorter-term counterparts.
The Federal Reserve controls the fed funds rate, the rate at which banks can borrower on an overnight or short-term basis from the Fed. This has the largest impact on short-term rates, and experts project that in a normalized yield curve environment, the 10-year treasury should be 100 – 150 bps (1.00% – 1.50%) above the fed funds rate. Cuts in 2024 were prolonged from an initial expectation in Q1 to ultimately not occurring until the end of Q3.
Beyond this and perhaps the biggest move, was the Fed’s upward adjustment of their expectation of where the fed funds rate will land in 2025. The graphic below shows a comparison of the Fed’s projections at their September 18, 2024 meeting, reporting a split majority between a 3.00% – 3.50% effective fed funds rate, to their projection on December 18, 2024, which provided a substantial majority at a 3.75% – 4.00% effective rate. This revision put significant upward pressure on treasury rates across the yield curve. The primary reason for the Fed’s revision was the expectation that inflation would actually increase in 2025 to 2.5%, over the YE forecast for 2024 of 2.4% (at the time of the meeting).
It is possible that some relief could come in rates, but all expectations are for inflation to remain stubborn and the Fed to remain their currently charted course. This is in contrast to investors’ previous expectation of a much lower fed funds rate that would have resulted in lower treasury rates and ultimately some much-desired reprieve for CRE Borrowers.
Liquidity for real estate flows from the institutional level down and impacts all levels below it on the food chain. At the institutional level, exposure to real estate comes in many forms. There is equity exposure in the form of direct or LP investment; many investors are lenders or invest in private credit; and there is a primary and secondary market for real estate mortgage-backed securities. Appetite for all of these investments provides for liquidity across the board for CRE investors and is what allows for transactions to take place.
Exposure to any of these elements would be considered commercial real estate investments from an institutional or large investor. Real estate investment is part of the larger category of alternative investments. Alternative investments are considered anything other than stocks, bonds, or cash. Commodities, private equity, private credit, hedge funds, cryptocurrencies, and infrastructure are some of the other primary alternative investment types.
One challenge for the CRE industry is that real estate was perceived as a poor risk-adjusted return compared to other alternative investments. When asset prices were at an all-time high and interest rates were low, equity investors had exposure at a level the market had not seen, and debt investors were exposed at similarly high levels earning little yield. Now that values have come down 20% – 40% from their peak and rates are up and somewhat stable, CRE is presenting a compelling case for investment at the institutional and large investor level again. This has provided significant interest and allocation from the capital markets to all facets of commercial real estate exposure. This liquidity will provide for more debt and equity options for CRE investors, which will increase the ability to get transactions done.
One benefit to the increased capacity for lending as well as demand for in investments in the commercial mortgage-backed securities market is that it will create downward pressure on credit spreads. Pure competition as well as demand for the products they create will help lenders lend at lower spreads over the treasury rates, which serve as the baseline index for the loans. This will help somewhat offset the higher-than-expected treasury markets, which are ultimately driving interest rates higher than expected as noted above. While the spread compression cannot fully offset the increased treasuries, any reprieve will certainly be welcomed by the markets.
Overall, there is substantial demand for CRE investment gearing up for 2025. Many lenders will force transactions in the face of higher-than-expected interest rates. The substantial amount of liquidity on the equity side will provide some competition and help close the horrid bid-ask spread that has existed for the past two years. Liquidity in the debt markets will also provide solutions for borrowers who need to take on leverage to complete their transactions. While it seems like no two years have been the same since the pandemic started, it seems that despite the challenges that exist, CRE investors are ready to get back to transacting at scale in 2025.
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