As Fed Rate Hopes Shift, So Too Does Real-Estate Sentiment
Key findings
- High borrowing costs have been a pain point for real-estate investors. It’s made deal financing more of a challenge and put pressure on asset values.
- Hopes that relief would arrive in the form of rate cuts by the Federal Reserve have so far been thwarted by sticky inflation and robust labor markets.
- As anticipated rate cuts have moved further out, investor sentiment in commercial real estate has softened.
Like rollercoaster enthusiasts or dubstep fans, many real-estate investors have found themselves eagerly waiting for the drop; specifically, a drop in interest rates whenever the Federal Reserve begins an anticipated loosening of monetary policy. This is because the asset class has been rocked by a rapid rise in interest rates that has stymied deal activity and put downward pressure on asset values. But investors hoping that rate cuts from the Fed will help ease the pressure have been disappointed as markets have consistently dialed back rate-cut expectations on the back of sticky inflation and stronger-than-expected labor-market conditions. This disappointment in turn has weighed on investor expectations for commercial real estate. It's worth understanding this dynamic, as investors work to determine the best way forward — especially considering the fact that lower interest rates may not necessarily be the panacea they hope it will be.
Investor sentiment has softened
Using the Pension Real Estate Association (PREA) quarterly consensus survey, it is possible to show how investor views on U.S. commercial real estate have weakened over recent quarters. Investors were forecasting a total return of 7.9% for the 2024 calendar year back in early 2022, however, this outlook has progressively declined over time. In Q2 2023 it was down to 3.3%, and in the most recent survey during the second quarter of this year, it was down to -2.0%. Expectations for 2025 have similarly moderated, down from 6.4% in Q1 2023 to 5.0% in the last survey. Forecast total returns for 2026 have also declined; between just the Q1 and Q2 2024 surveys, the forecast return dropped by 0.5 percentage points.
Commercial-property returns and PREA survey forecasts
Source: MSCI U.S. Quarterly Property Index, PREA Consensus Forecast Survey, Pension Real Estate Association
Interest-rate expectations have played a role
What is clear is that investors have gradually adjusted their outlook for the asset class, tempering their expectations for when a recovery will occur. This shift in sentiment can be explained, at least in part, by changing views on the trajectory of interest rates.
As the exhibit below shows, financial markets have consistently overestimated the likelihood of easing since rates started rising in 2022. With inflation being slower to abate and labor-market conditions remaining robust, forward curves have shifted up and out over time, pushing back rate-cut expectations.
Realized fed-funds rate vs. 36-month forwards
Note: Forwards use yield curve at end of each quarter, MSCI curve name: USD Fed Funds OIS (SP)
Higher rates have been a notable pain point for commercial real estate. The rate on newly originated commercial mortgages tracked by MSCI increased from 3.5% in September 2021 to a high of 7.5% in October 2023, declining slightly but remaining around 7% in more recent months. This has made it more difficult for investors to borrow and refinance, which has reduced transaction demand and, together with higher discount rates, put downward pressure on asset values.
Yields and mortgage rates
Source: MSCI, Moody's, Federal Reserve
The knock-on effect of interest rates rising higher and staying elevated for longer than markets had anticipated has been a softening of total-return forecasts.
When will rate relief arrive?
While, of course, no one knows for sure, recent rate cuts by central banks in Canada and Europe may have given investors some hope that a turning point in U.S. monetary policy is approaching. But while some Fed officials have suggested that they are closer to cutting rates, markets are not currently pricing in cuts for the Federal Open Market Committee (FOMC) meeting on July 30-31.[1] Investors may have to wait until at least the Sept. 17-18 meeting, for which markets are currently pricing in a quarter-point cut. Or perhaps longer if markets are still mispricing the macro landscape.
It is also worth noting that rate cuts alone will not solve all the challenges real-estate investors face, with many markets still working through post-pandemic challenges; most notably the CBD office market where demand has been reshaped by remote work. Further, there may be an element of "be careful what you wish for," as there are potential downside growth risks to consider. For instance, a recession or banking crisis could theoretically hasten rate cuts but would be unlikely to have positive impacts for real-estate investors.
1 Howard Schneider and Michael S. Derby. “Top Fed officials say they are 'closer' to cutting interest rates,” Reuters, July 17, 2024.
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