But will rate cuts be enough to bring stability to commercial real estate (CRE) valuations and increase transaction volume? Only time will tell; however, a wave of refinancings set to come due over the next few years, a sustained higher cost of capital, and the need for increased equity investment will present challenges and potential opportunities for the industry.
Transaction volume in 2023 was 31 percent lower than in 2022, according to CoStar data, as the CRE market continued to navigate fluctuating valuations. However, the 10-year Treasury yield signals where investors’ risk premium will price commercial real estate. According to CBRE, historical data suggests that a 100 basis point increase in the 10-year Treasury results in a 60 basis point rise in capitalization rates. The average U.S. national index cap rates for retail real estate ended 2023 up 52 basis points compared to the second quarter of 2022, while office was up 71 basis points over the same time period. These increases may be a hopeful sign that we are close to closing the gap between buyer and seller pricing in these core sectors. Quality is proving to hold strong, as Class A office properties saw only a 40 basis point increase in cap rates for the same period.
However, multifamily and industrial — both red-hot sectors in the post-pandemic period — may now experience further compression. According to CoStar data, multifamily cap rates rose 121 basis points since the second quarter of 2022. The sector ended 2023 with an average cap rate of 6.8 percent, in line with 6.6 percent at the close of 2019, directly ahead of the pandemic. This indicates multifamily is now resetting from temporarily low cap rates. The industrial sector, by comparison, has seen a rise of only 27 basis points during the same period, attributable to strong fundamentals from inflated cash flows and demand for last-mile logistics centers. We are likely to see further cap rate increases in certain industrial markets and subsectors as inflation eases and tenant leases turn over.
While increasing stability in both monetary policy and yields will help ease the cost of borrowing, costs will remain high, keeping cap rates elevated despite further drops expected in the 10-year Treasury yield through 2026. A larger spread between long-term yields and CRE cap rates will draw investors back into all commercial sectors as their risk appetite returns and will likely boost transaction volume beginning in the second half of 2024 following interest rate cuts. However, compression of valuations poses a greater concern for owners looking to refinance and avoid distressed asset sales.
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Commercial properties have approximately $5.82 trillion in outstanding debt, of which $2.8 trillion is scheduled to mature in the next five years, according to Trepp data. These maturing loans will generally face higher interest rates than at origination, as debt yields have doubled since early 2022, compressing returns. Lower-performing assets, which include much of the outdated office space across the country and in metro areas with lower return-to-office rates, may not be able to refinance or bear the higher cost of capital.
Mezzanine fundraising was a standout in 2023, with $40.6 billion raised as of the third quarter of 2023 compared to 26.2 billion in the full year of 2022, Preqin data shows. Mezzanine positions come with higher returns than direct lending, but also carry additional risk due to their subordinate position in the capital stack. While $536.9 billion of debt matured in 2023, delinquencies for most asset classes, excluding office, remained relatively low and stable over the trailing 12-month period ending December 2023.
Not surprisingly, the commercial office sector had the highest year-over-year increase in delinquencies, jumping to 5.82 percent in December 2023 from 1.58 percent in December 2022. In the near term, we expect to see more delinquencies as office debt continues to come due. However, we are optimistic this trend will level off amid increased clarity around property valuations and longer-term corporate plans for office expansion. Some 46 percent of middle market executives plan to increase their organization’s number of physical workspaces over the next two years, according to data from the Q4 2023 RSM US Middle Market Business Index survey.