Commercial real estate has faced varied challenges in recent years, from high interest rates and rising inflation to elevated borrowing costs and remote work’s impact on where and how occupants utilize space.
While uncertainty remains, economists interviewed by REIT.com say the market is showing early signs of recovery. They expect lower interest rates and subsiding inflation as well as stabilizing asset values and renewed investor confidence. They’re also seeing improving fundamentals in terms of the cost of capital and capital availability.
REIT.com spoke with: Mariya Letdin, Kyle Riva associate professor of real estate at Florida State University’s College of Business; Abby Rosenbaum, associate director, real estate economics at Oxford Economics; Eva Steiner, professor of real estate at The Penn State Smeal College of Business; and, Susan Wachter, Albert Sussman professor of real estate and professor of finance at The Wharton School of the University of Pennsylvania.
Based on what you have seen in 2024, how would you characterize economic fundamentals for the CRE sector in the coming year?
Mariya Letdin: Retail is a star. Industrial is stable. Multifamily is stable in most markets. I think 2025 will be more of the same. Office will continue to be a problem child for a while, and the other sectors are mostly solid.
Abby Rosenbaum: For 2025, I would expect a little bit of what we saw in 2024, so things look solid for the U.S. economy. We’ve raised our 2025 GDP growth forecast slightly, and we expect the unemployment rate to decline next year.
Eva Steiner: Going into 2025, there are signs that we can be a little bit more optimistic. Of course, the Federal Reserve’s recent interest rate cuts are expected to stimulate economic activity, which will then potentially lead to increased investment appetite in commercial real estate. If that is then accompanied by healthy economic growth, the real estate sector may be set up for a more positive environment next year.
How do you see the interest rate landscape impacting fundamentals?
Susan Wachter: The expected robust economic growth is likely to result in higher-for-longer federal funds rates. Moreover, the Fed can only control the short end of the curve. The five- and 10-year Treasury rates have already increased meaningfully. These moves will slow down the recovery of oversupplied and overbuilt commercial real estate sectors.
Letdin: Of course, it's easier to make deals work with lower interest rates, and it would be easier to refinance a lot of recent and vintage loans if rates were to come down more. I think everyone is waiting for that to happen. What has occurred is a little bit of an “everybody freeze” situation. The activity has slowed to a halt, and one or two things will happen. Either everyone will be tired of standing frozen and will resume transacting at lower values, or rates will continue to fall, and everyone will resume transacting. Either way, I think things will pick up in 2025.
Rosenbaum: Lower interest rates could lead to more borrowing and improved consumer confidence, meaning that people would be more apt to spend. That could be a tailwind for retail and industrial, with e-commerce increasing demand for warehouse space. Lower interest rates should help bring mortgage rates down, so there could be a slight transition to more home purchases. I don't see a material impact on multifamily rental demand, but it could mean that renters are slightly less sticky.
What is the state of financing conditions for commercial real estate?
Steiner: Financing conditions are showing some signs of improvement, and the recent interest rate caps are expected to help stimulate borrowing, and therefore, investment. I've heard U.S. bank CEOs express some optimism in terms of anticipating an increase in borrowing demand, so all that could lead to an uptick in lending activity.
Wachter: Upcoming maturities on investments that were financed in 2021 and earlier are likely to require substantial equity infusions to refinance. That means available financing will be at a lower proceeds level than existing leverage. To the critical question of whether banks will be able to weather the office problem, the answer appears to be yes, as their balance sheets are overall in good shape. REITs are, in general, well situated to borrow and deploy capital.
Letdin: Financing conditions are also asset specific. Office is a nonstarter for a lot of lenders. Loan-to-value (LTV) ratios overall are very conservative, and that’s just a function of where the rates are. It's hard to make deals work with higher leverage. You have LTV ratios between 50% and 60%, and that's good. I think everyone is hungry. It's hard to sit and just watch things not happen. People didn't want to recognize new values, and sales activity was very low. I think lenders were also worried about a recession potentially, and those fears have somewhat been alleviated. I think lenders are ready to go to work in 2025.
What is the major economic barometer you will be watching most closely in the coming year?
Rosenbaum: I'm watching the 10-year bond yield. Certainly, I’m watching the Fed funds rate as well. But from our forecasting standpoint, seeing how bond yields are performing and that expectation of where they're going, is helping me gauge how real estate investors might be feeling.
Letdin: I always watch jobs. I can't get off that hill. Jobs just drive so much of everything else.
Wachter: I’m watching interest rates because that's really the great unknown. Growth is in store. There’s no question. No doubt there will be Fed funds rate relief, but what does renewed growth do to long-term interest rates?
Steiner: Because there are so many competing factors that will influence interest rates going forward, closely monitoring the monetary policy decisions that the Fed makes will be crucial, because that, of course, influences interest rates, inflation, and overall economic stability.
What are you seeing in terms of supply and demand forces across the CRE sector?
Letdin: It takes so long to correct imbalances in supply because the approval and building cycles take forever. Even if we think there's a shortage of some product type today, like grocery-anchored retail, it’s very difficult to create more of it to be available, so there's just this lag of imbalance.
We saw that a bit with residential after the financial crisis, when some markets claimed they had speculative activity, and perhaps too much supply. Then there was the retail apocalypse. No one was building retail, and now retail is very tight.
Wachter: With consensus of 2025 GNP growth at 2.5%, the underlying strength of the economy is shoring up the demand side of the commercial real estate market. How this plays out depends on the sector. There is still oversupply in the relatively favored multifamily and industrial sectors. But both will see absorption and declines in vacancy.
Nationally, the multifamily vacancy rate, currently around 8%, is expected to peak at this level this year, with rents flat or expected to still fall in oversupplied markets in the South and West.
Industrial will benefit from onshoring but also has some oversupplied markets. With supply down, the industrial vacancy rate will peak in 2025 at a rate closer to 7%. Office is another matter and remains bifurcated. As old leases expire, vacancies in older buildings are likely to increase, with well-located offices with attractive amenities continuing to do well.
Rosenbaum: We expect that the elevated completions we have seen in the industrial and residential sectors will continue to subside. Going into 2025, as new supply retreats, there will be a rebalance because the underlying demand for industrial and residential is there. We just need a little bit less supply to rebalance things.
For office and retail, primarily non-destination malls, they're still going through a structural shift. The demand piece is the struggle for these two sectors. You have to figure out where the demand is, and how to adjust to that demand.
Steiner: I see two important trends. One is the pace of technological integration, and that’s the adoption and development of AI and data analytics in terms of property management. However, it’s also the increased demand for the integration of all kinds of AI applications, which could change tenant demand, especially in tech-oriented locations. Second is the trend toward sustainability and green building practices, and the growing demand for developing energy-efficient and environmentally friendly buildings.
What level of transaction activity do you expect to see for CRE?
Wachter: I expect transaction activity to improve from its recent lows but remain at depressed levels. Multifamily and industrial are picking up, but the office market is down and out.
Steiner: If we continue with a benign and positive economic outlook accompanied by lower interest rates and stabilizing fundamentals, I think that's going to affect investor sentiment, and that could lead to increased deal activity.
Rosenbaum: Real estate investor confidence is starting to improve. Transaction activity is still tepid, year over year, but much improved compared to the double-digit declines we saw a couple of years ago.
Letdin: According to third quarter data, transactions are coming back in gateway cities. By that, I mean the true premier markets with very strong employment centers like Manhattan and central Washington, D.C. Those markets are always leading indicators, so that’s a clear sign that more markets will follow. How quickly will that momentum build? I don't know.
Are there other trends or developments that could impact commercial real estate going forward that you are keeping a close eye on?
Rosenbaum: I’m watching the policy implications from the second Trump presidency. I’m keeping my eye on tariffs, immigration, tax cuts, and those types of things. There would likely be short-term and longer-term effects for commercial real estate.
Wachter: One question is whether and how fast central cities will come back. How’s that going to play out, and what's the fundamental impact of remote work over the longer run? We still don't know what the final playout will look like. What we've seen is a move to lower-cost markets, a move to the suburbs in terms of housing, and a movement away from the use of office space. But is that the end game? I don't think so. I’m hopeful that we're going to see a resurgence of downtown activity including office. That's not a 2025 story. That’s further out.
Steiner: One trend that could be quite significant is the continued reuse and conversion of former office properties. We’re seeing office-to-residential conversions fueled by the decline in demand for traditional office space. That decline, coupled with affordability problems in the housing market, means the potential office-to-residential convergence, especially in big metropolitan areas, could be very interesting to watch.