The commercial real estate recovery is on, but the rebound may be uneven

The tide could be turning for commercial real estate.

The Federal Reserve began its interest rate cutting cycle in September, lowering the Fed funds rate for the first time since 2020 by 50 basis points, while hinting that more cuts are on the horizon. That could give interest rate-sensitive sectors such as commercial real estate long-awaited positive momentum.

Lower interest rates make debt cheaper, helping to accelerate deal flow in an industry where deal activity had stalled into the second quarter of 2024. The CRE market had been pressured in the years after the initial Covid shutdowns, ending a nearly 15-year bull run in the face of higher borrowing costs, weak tenant demand and increased property supply. As a result, property values and sales declined.

The Fed's shift in policy is "the most notable green shoot" for the CRE market, Wells Fargo analysts wrote in a Sept. 3 research note. While lower rates are not a "magic bullet," the easing of the Fed's monetary policy "lays the groundwork for a commercial real estate recovery," analysts wrote in a follow-up report in late September.

For higher dividend-paying stocks such as REITs, lower rates make these fixed-income investments more attractive for investors. But the primary impact of interest rate cuts is psychological, according to Alan Todd, head of commercial mortgage-backed security strategy at Bank of America.

"Once the Fed starts to cut, they'll continue along that path," which fosters a sense of stability, Todd said. As the market feels more comfortable, it will "incentivize borrowers to get off the sideline and start to transact."

Refinancing and sales volumes are already picking up as sentiment around the sector improves, according to Willy Walker, CEO of CRE financing firm Walker & Dunlop, in an interview with CNBC in late September.

During the Fed's tightening cycle, rising rates caused a standoff between buyers and sellers where buyers hoped for lower prices while sellers clung to inflated valuations. This stalemate froze the deal market, prompting investors to adopt a wait-and-see mindset, leaving many to wonder what's next for the market.

But more recently, overall transaction volumes saw their first quarterly increase since 2022 in the second quarter of 2024, driven by sales in the multifamily sector, analysts noted.

More than $40 billion in transactions occurred during the second quarter, a 13.9% jump quarter over quarter, but still 9.4% lower year over year, according to real estate data intelligence firm Altus Group.

With deals ticking up and supply coming down, property valuations appear be improving as the MSCI U.S. REIT Index showed a steady increase since the spring into September, Wells Fargo analysts noted in their Sept. 25 research.

While these dynamics could set the stage for a broader recovery, with some major subsectors such as commercial retail real estate picking up in tandem, the path forward will likely be uneven.

The office sector of the CRE market continues to face a number of challenges, despite some signs of modest improvement in the second quarter.

Wells Fargo reported that for the first time since 2022, office net absorption — an industry metric used to determine the change in occupied space — turned positive, with over 2 million square feet taken up during the three-month period.

"Although modest, this was the best outturn since Q4-2021," according to analysts. However, this small victory wasn't enough to offset rising vacancies, as supply continued to outpace demand for the 10th consecutive quarter, pushing the availability rate to a new high of 16.7%.

In major cities such as Manhattan, office buildings in June had an average visitation rate of 77% of 2019 levels — the highest monthly total since the Real Estate Board of New York began tracking in February 2023.

Still, Wells Fargo analysts point out that "the headwinds still greatly outnumber the tailwinds," with hybrid work and a downshift in office job growth continuing to weigh on demand.

Prices remain below pre-pandemic levels, with central business district office prices down 48.7% since 2019, according to the analysts.

Beyond the temporary disruption of remote work, there are "structural challenges" that have intensified the industry's difficulties since the pandemic, including low demand, soaring vacancies and flat rents, according to Chad Littell, national director of U.S. Capital Markets Analytics at CoStar Group.

"Recovery looks distant," for the CRE office sector, Littell said. "While other property types are finding their footing, office may have a longer road ahead — perhaps another year or more before prices stabilize."

Multifamily real estate assets, on the other hand, have experienced an uptick in demand, with net absorption reaching their highest level in almost three years during the second quarter, according to Wells Fargo's research.

That's true even as construction of multifamily housing booms, with completed units on track to exceed a record 500,000 this year, according to data from RentCafe. By the end of 2024, developers are set to complete more than 518,000 rental units.

The multifamily sector was a pandemic darling within CRE as rent growth hit double digits in 2021. But that growth rate has since slowed to around 1%.

Yet this increase in demand suggests a shift in consumer behavior, as "households are taking advantage of greater apartment availability, generous concessions and more manageable rent growth," Wells Fargo said.

Among the factors pushing renters to multifamily is a lack of affordable single-family homes for entry level. This trend is underscored by the stark contrast between homeownership costs and rental expenses: The average monthly mortgage payment reached $2,248 during the second quarter, 31% higher than the average monthly apartment rent of $1,712, Wells Fargo said.

Multifamily is also benefiting from stabilizing vacancy rates. For the first time in over two years, vacancies didn't rise during the second quarter, holding steady at 7.8%. This stabilization, combined with the 1.1% average increase in rent, indicates a healthier balance between supply and demand.

Looking ahead, the outlook for the multifamily sector remains positive.

Wells Fargo analysis suggested that "high homeownership costs should continue to support rent demand," meaning that current trends favoring multifamily housing are likely to persist in the near term.