Commercial real estate (CRE) is inherently cyclical, experiencing phases of expansion and contraction. For instance, the COVID-19 pandemic prompted a shift from urban centers as people sought more space, driving a surge in housing demand. Coupled with exceptionally low post-pandemic construction financing costs, this led to a rapid increase in multifamily construction starts in cities with significant inflows of new residents. Now that new supply is being delivered, rent growth is facing downward pressure in a number of cities. However, with construction starts declining and financing now more expensive, future apartment supply will be limited, allowing demand to catch up. When it does, a new cycle begins, continuing the cyclical nature of the market.
Signs are pointing to the emergence of this new CRE cycle. More transactions are occurring, both sales and refinancings, and lenders are increasingly stepping back into the market. Originations of Commercial Mortgage Backed Securities (CMBS), a type of loan used for large properties or portfolios of properties, increased by 150 percent on an annual basis in 2024, indicating that bigger players are stepping back into the purchase market.
If the adjustment period seems to be slowly coming to an end, the natural next questions are: what will the next CRE cycle look like? How will it be different from the last, and what will its distinct phases be? This is what we’ll investigate in this edition of the X-Factor.
Gone are the days of double-digit rent growth. In this cycle, success will be determined by carefully scrutinizing expense details and finding acquisition targets that are profitable enough at lower LTV ratios to attract investors.
Get Used to Higher Interest Rates
Over the past three years, many speculated about when rate cuts would begin. However, few seriously considered the possibility of long-term rates remaining high for the foreseeable future. Therefore, it surprised many when the yield on the 10-Year Treasury bond, a crucial benchmark for CRE, increased after the Federal Reserve (Fed) started cutting short-term rates in September 2024. Since the beginning of the new year, the 10-Year Treasury yield has hovered between 4.3 percent and 4.8 percent, or roughly 0.7 percent to 1.2 percent higher than before those rate cuts began. This disconnect is due to the fact that the long end of the Treasury yield curve is set by the market rather than by central bankers. The short end of the yield curve only indirectly affects the long end by impacting investors' willingness to commit their capital for extended periods to achieve specific yields.
It's now time to more seriously consider that rates are going to remain elevated. The top part of the following chart shows the 10-Year Treasury rate over the last 70 years. Recessions are labeled in grey, and the average inter-recessionary yield on the 10-Year Treasury is labeled for each inter-recessionary period. Taken in this historical context, current rates aren’t high – they only feel high because we just came out of a decade-long period of unusually low interest rates, which was preceded by three decades of continuous interest rate declines.
The CRE market can function healthily in a higher interest rate environment, as it has in the past. It’s the rapid rate of change that creates disruption. While much of the adjustment in CRE prices has already occurred over the last two-to-three years, it’s also plausible that the 10-Year Treasury, which hit a 40-year low in 2020, will now increase or move sideways for the foreseeable future. The tailwinds from long-term interest rate declines that benefited the CRE market from 2010 to 2020 do not seem to be with us at the beginning of this next cycle.
Less Debt, Lower Returns
Fortunately, the recovery doesn’t depend solely on interest rates. While lower interest rates would certainly encourage greater demand to purchase commercial properties, property prices have already fallen enough to offset some of these higher debt costs. Still, higher interest rates reduce the quantity of debt that buyers can afford to use to purchase buildings, and using less debt results in lower investment returns, all else equal, since it limits the impact of the leverage effect on equity returns. Therefore, lower loan-to-value ratios will likely result in lower returns this cycle compared to the last.
Distressed Debt Will Take Longer to Resolve Than Price Stabilization
The transition from recovery into the beginning of the next cycle will happen gradually and in separate phases. Specifically, property prices will recover before all debt distress is fully resolved. Typically, lenders prefer to have borrowers work their way out of a problem rather than seize collateral and deal with it themselves, although investor lenders can be more flexible than banks and will sometimes “loan to own.” This often leads to a loan restructuring, which usually involves an extension and some adjustment of terms, all with substantial lender involvement.
The chart below shows roughly where we are in price recovery and distress resolution, each of which will have their own timelines. Prices are still declining on an annual basis for many asset classes, but are close to stabilizing. On the other hand, distress, as indicated by delinquency rates and outstanding distressed loan balances, continues to grow. According to data from the Mortgage Bankers’ Association, $384 billion of commercial mortgages that were due in 2024 – approximately 41 percent of all commercial mortgages due last year – were extended into 2025, which is comparable to the proportion of maturing loans that were rolled from 2023 into 2024. This indicates that at the start of the next cycle, we will simultaneously see both ‘good news’ with rising transaction volume due to stabilizing prices, and ‘bad news’ as distress takes longer to resolve.
Once that distress is resolved, lenders will have more capital available to lend. At that point, credit contraction will transition into credit expansion and both prices and transaction activity will benefit as investors have greater access to debt. Currently, we are only part of the way into the price stabilization phase – distress will remain with us for some time.
Managing Expenses Will be Paramount
This cycle will require more careful expense management than the last. Compared to pre-pandemic, growth in insurance premiums and repairs and maintenance (R&M) costs, two major operating expenses for commercial properties, has outpaced growth in rental income. From 2019 to 2023, insurance premiums for multifamily and nonresidential properties increased by 34 and 50 percent, respectively, while R&M expenses increased by 34 and 36 percent from 2019 to 2024. Managing insurance premiums is a challenging task. While larger operators may have sufficient negotiating leverage to limit premium increases, smaller ones typically don’t and will face the full brunt of higher premiums. Property taxes are also generally beyond the control of property owners, as they are determined by local government authorities.
One category that can be more carefully managed is R&M. Arguably, this is one of the least sexy parts of managing commercial property – toilets, leaks, and drain stoppages, oh my - but it will be the line item that makes the difference between a 60 percent and 65 percent net operating income (NOI) margin. This will especially be true in the first part of the cycle that will be accompanied by large deliveries of apartments and industrial space, which will limit rent growth in some areas for those types of properties. Things like checking for double billings or overcharges, making sure vendors aren’t electively performing services they haven’t been authorized to do, and cutting out middlemen by buying material and appliances directly from suppliers, are all examples of active expense management that can help maintain profit margins. For smaller mom and pop operators, it may even involve swinging more hammers yourself, if possible.
So, What’s the X-Factor?
The long-anticipated start of the new CRE cycle seems to be upon us. While new cycles typically offer opportunities to savvy operators who manage risks well, this emerging cycle appears to present more significant operating and financing challenges than the previous one. Gone are the days of double-digit rent growth. In this cycle, success will be determined by carefully scrutinizing expense details and finding acquisition targets that are profitable enough at lower LTV ratios to attract investors.