Market outlook brightens: Commercial real estate in 2024

The commercial real estate sector is emerging stronger after a challenging year. In 2023, a dramatic increase in interest rates, expectations of a recession, a liquidity crunch, and a wide bid-ask spread suppressed CRE investment activity. Market uncertainty and destabilizing conditions pushed buyers to the sidelines in favor of portfolio management strategies. Acquisitions dropped precipitously. Some investors even popularized the phrase, “Survive to 2025,” to describe the mindset of waiting out the market. There seem to be some signs of an improving environment, according to experts at KeyBank Real Estate Capital, who expect this year to be a better environment for increasing transaction volume. 

KeyBank experts Dan Baker, head of the commercial mortgage group; Andrew Lucca, head of the income property group; Jim McLaughlin, head of institutional and healthcare real estate lending; Wally Neil, head of real estate syndications for KeyBanc Capital Markets; and Kevin Murray, regional sales manager of institutional real estate, weighed in on the market’s changing dynamics in 2024 and the opportunities now emerging for investors.
 

Renewed optimism defines 2024

While market uncertainty hasn’t dissipated, investors are showing a renewed sense of optimism in the year ahead. “Big picture, I think this year is going to be better than last year, because most people have completed portfolio management strategies and have perspective on their current situation,” says Baker. The brightening outlook comes tempered with a sense of caution — but investors are encouraged by the stabilizing interest rate environment, a 3% inflation rate, and the relative preservation of values, considering the market challenges of the recent past.

Optimism has yet to translate into increased transaction volumes. Private equity players have remained on the sidelines, waiting for proof of market stability. Unfortunately, without transaction velocity, it is difficult to assess property values and market trajectory. “There is a tremendous amount of liquidity sitting on the sidelines,” says Murray. “Once we get some semblance of volume, we can get a better understanding of where pricing is. This year, we are expecting transaction activity to pick up — and hoping for more stability in interest rates.”
 

Investors seek creative acquisitions

Investors have widely anticipated a wave of distressed assets and forced-sale opportunities. However, those opportunities are not as plentiful as some had hoped. Many current commercial real estate owners are sitting in a good position, often with low leverage and low-interest-rate debt, providing them the resiliency to ride out the market turbulence. “Private institutional investors don’t expect any forced-selling opportunities are going to emerge in the next six months,” says Neil. Even if a property value fell 5% or 10%, if the borrower is underwriting to 60% or 65% leverage, there is still equity in the deal. That has created a market where owners are able to hold onto assets despite higher interest rates.

Although some segments of the market now have some welcome stability — a characteristic that is good news for everyone — investors are still struggling to find acquisition opportunities. While a property might not be distressed in a traditional sense, it may have operational challenges, debt maturities, high leverage, or subordinate debt. 
 

Plateauing rates

For the past two consecutive meetings, the Federal Open Market Committee has left interest rates unchanged and signaled plans to reduce interest rates in 2024. Experts have offered mixed forecasts about the timing and frequency of potential rate reductions, but the widely anticipated end of the Federal Reserve’s aggressive quantitative tightening campaign has helped to improve investment sentiment in commercial real estate.

Andrew Lucca said he expects that rates will stabilize this year but remain high as the Fed continues to focus on inflation. Rate cuts will largely depend on Consumer Price Index trends this year. “I think the Fed is going to hold higher for longer because they can, because the economy continues to hold up,” he says. Following plateauing rates in the first half of 2024, he expects rate cuts will come near the end of the year. “Banks are not assuming large-scale cuts in the first half of the year,” he adds.

Although rate cuts may come in the second half of the year, investors shouldn’t automatically wait for lower rates, advised the leaders. If capital is available to fund deals in the current environment, borrowers should take advantage. If a deal needs to get done, either because a loan is maturing or for an acquisition opportunity, it’s best to secure capital now. It is more beneficial to pay more for a five-year note and wait for interest rates to fall than to secure a 10-year note today. More important than the rate itself or the cost of capital is interest rate stability. Reduced interest rate volatility will help restore confidence in the market.
 

Alternative capital solutions

The traditional major sources of capital, like Fannie Mae and Freddie Mac, commercial mortgage-backed securities and life insurance companies, are all back in play this year — but those aren’t the only ways to get a deal done in the current market. On behalf of their clients, the KeyBank team has focused on tapping into alternative capital sources. By bringing unique capital solutions to the table, they can close financing gaps and push deals across the finish line. For example, Baker says that they have closed permanent loans with preferred equity partners, as one solution. “We examine the portfolio holistically to understand what strategy would really benefit the client,” he says. “It is a more institutional approach.”

The team continues to support clients in this challenging environment by providing more comprehensive financing solutions. Murry says such solutions might include hedging, or advising clients to simply wait until there is more stability in the market. That is particularly true for owners with liquidity and low leverage who have the option to wait through this interest rate environment — if it makes sense for their business plan.

Asset classes play 3:1

It is easy to speak generally about capital market trends in commercial real estate, but the reality is that each asset class operates in its own orbit. Of the four major real estate groups — multifamily, industrial, office, and retail — three are poised to rebound this year, while another may continue to struggle. Multifamily is the best-performing asset, in terms of demand, cash flow, and asset values. Likewise, retail and industrial continue to perform and maintain their valuations. While these three asset groups have lost some value and each has stress due to macroeconomic challenges, they have continued to perform through the down market.

Office properties, on the other hand, are experiencing significant stress compared to the other major product types. “Office properties have underlying structural issues related to demand, not just interest rate volatility,” says Murray. In many ways, there are two parallel markets in commercial real estate, office and the other sectors. Office has genuine issues with demand fundamentals, while the other asset classes have only been impacted by the broader economy. “A lot of time, people talk about the real estate market and they start mixing up asset classes,” says Lucca. “Today, a lot of the conversations about office properties start bleeding into the other commercial property types, where the concerns are just not applicable.”

For the past year, commercial real estate stakeholders have kept a sharp eye on interest rates, liquidity, and leverage, waiting out widespread uncertainty. This year, there is hope that the storm clouds may clear.