Insights into U.S. Commercial Real Estate Dynamics Amidst Rising Interest Rates

 Source: Chad Littell, CoStar Analytics

Historically, Property Values Don’t Increase Until Two Years After Sales Activity Rebounds

 

Since March 2022, when the Federal Reserve initiated a series of benchmark interest rate hikes, there has been a decline in sales within the U.S. commercial real estate market. Investors are adopting a cautious 'wait-and-see' approach as they assess the potential impacts of increased borrowing costs.

With commercial property owners staying on the sidelines, the complete price discovery process is yet to unfold. The current market environment suggests that a rise in sales activity may put pressure on asset prices as the economic consequences of higher borrowing costs become clearer.

Drawing from the experience of the previous commercial real estate downturn, the next few quarters could represent the nadir in sales activity, as sidelined capital returns to take advantage of discounted assets. The majority of unallocated investment capital, often in the form of value-add and opportunistic capital, has the potential to influence asset prices and shift the market dynamics. Since the decline in transaction volumes began in 2022, seven quarters have passed, and historical patterns indicate that a bottom in sales velocity may occur next year.

To illustrate, during the first quarter of 2007, office deal volume reached its peak at 4,232 sale transactions, but it significantly dropped to just 1,656 sales in the first quarter of 2009. It took two years for office transaction counts to stabilize. In the subsequent two-year period until 2011, transaction volumes increased by 63% from their lows. However, the median office price per square foot continued to decline, dropping an additional 22% between the first quarter of 2009 and the first quarter of 2011. The prolonged search for price stability, coupled with a surge in transaction flows, exacerbated the decline in prices as each new transaction reinforced the downward trend.

 

 

 Similarly, the industrial and retail sectors experienced a related pattern where two years of falling transaction totals were shadowed by two years of price discovery. From the second quarter of 2007 to the first quarter of 2009, the industrial market saw its deal flow shrink by 61%. Once the deal velocity returned to the market, increasing 74% in two years, industrial gave back another 16% of overall value before finding its footing and recovering in the first quarter of 2011.

Despite seeing transaction counts for retail properties recover in the first quarter of 2009 after 15 months of declines, it took nine quarters for retail prices to bottom out after sale transactions rebounded by 119%. The median retail price per square foot established a new cycle low in the second quarter of 2011 after giving up an additional 18% of value as lower sale comparables reinforced the pricing trend.

 

 

 However, the multifamily sector stands apart from other major asset types in bucking this trend. Due in part to its 12-month lease structures, rental apartments are the most sensitive to swift economic changes as it was the first-in and first-out of the last downturn. The process of two years of slowing transaction volume and two years of price declines also held true for multifamily, but the unique aspect of this sector is that these two-year periods overlapped — they happened simultaneously.

Pricing in the multifamily sector bottomed after just two years of declines coming out of the Great Recession. This short but pronounced period may provide leading price indications for the entirety of commercial real estate. Even though prices for multifamily sales stopped falling in late 2008 through early 2009 and shuffled sideways for the better part of a year, it was the first of the four major asset types to find price stability and did so a full two years ahead of the pack.

Source: Chad Littell, CoStar Analytics

 

Will Amorin | KW Commercial