Key Points:

• The recovery will not just be an interest rate story, but also a price story. 
  
  
• As property prices stem declines and stabilize, transaction activity will gradually follow. In the refinance markets, this rebound appears to already be occurring.
  
  
• Distress in debt markets will take longer to work out and will likely last beyond 2025.

The commercial real estate (CRE) market has suffered through a turbulent two and a half years. Heading into 2025, however, it appears to be on the precipice of a recovery. But what will that recovery look like, and how long will it last? Property prices will have to stop declining and slowly begin to increase. As lower and stabilized prices attract more buyers to market, transaction volume should begin to increase. More demand for CRE will eventually lead to moderate positive price growth. Debt distress will take longer to fully work its way through the system and will be one of the final aspects of the recovery to fully play out.

This month’s X-Factor investigates each of these major components of the recovery and explains why the timing for each will be different. 

CRE professionals should look forward to the new year, as most data suggests that a recovery is on its way. Stabilizing prices will give way to rising sales volumes, but distress in the capital markets will take longer to resolve and put some downward pressure on the supply of CRE credit.

Recovery in 2025 Won’t Just be an Interest Rate Story

Though interest rates will play an important role in attracting purchase demand to the market next year, the recovery will not just be an interest rate story. After all, CRE projects can still be profitable with expensive debt if a property is bought cheaply enough, and prices for nearly all CRE asset classes have been declining for roughly the last two years.

However, price declines have moderated for all asset classes except urban offices, which continue to decline at double-digit rates. If price declines continue to moderate at their current rates, all property types except urban offices will re-enter positive price growth territory by the end of 2025. This moderation in price growth is an indication that the gap in price expectations, which began to widen in 2022 after the onset of interest rate hikes, is narrowing. Convergence in price expectations will be a major driver of the recovery in transaction volumes next year.

Price Recovery Will Spur Increase in Sales Volumes

Since property prices have fallen substantially over the last two and a half years, it’s likely that sales volumes increase in 2025, even if interest rates remain “higher for longer.” The main driver behind this dynamic will be more buyers and sellers finding agreement on prices, which makes it easier to consummate sales. 

While sales volumes are still low compared to three years ago and to pre-pandemic levels, they appear to have troughed. As the top portion of the following chart shows, sales volumes on a trailing 12-month basis have hovered around $300 billion per quarter for the last four quarters. Transaction volumes in the refinance market, shown in the bottom portion of the chart, paint a picture that’s slightly more optimistic. Though refinancings, like sales, fell substantially when interest rates began to increase in 2022, they increased in the third quarter of this year on both a quarterly and an annual basis for the first time since the second quarter of 2022. While part of this is driven by slightly lower interest rates, broader agreement in prices also makes it easier for lenders to get more comfortable with asset valuations, a prerequisite to any refinance. 

Loan Origination Activity is Picking Up

The narrowing gap in price expectations won’t just impact buyer and seller activity, but lenders as well. As more lenders become comfortable with their assessment of collateral valuations, they will be more willing to increase lending activity. Indeed, this is already materializing. As can be seen in the following chart, loan origination activity increased substantially in the third quarter, by approximately 60 percent on an annual basis. While this growth is off a low level of originations last year, it’s nevertheless the first large increase in origination activity in several years. 

This recovery in origination activity occurred across lender types, with the largest increase occurring in the securitized loan market. Securitized loans, which includes Commercial Mortgage Backed Security (CMBS) and other types of conduit loans, are usually used to finance very large properties or portfolios of properties. The fact that these are increasing at such a rapid rate is a sign that bigger buyers are re-entering the market and that debt capital is increasingly available for them. 

Working Out Distress Will Take Longer Than Price Recovery

Debt distress in the CRE market will last beyond price recovery. To understand why, consider the process of a distressed asset sale. When an owner decides to walk away from their property, take a complete loss, and hand the keys back to the lender, the process the lender undergoes to recover collateral value is only beginning. That recovery process can be lengthy. What’s more, approximately $575 billion in CRE debt, or roughly 12 percent of all outstanding CRE debt, is scheduled to come due next year in an environment where prevailing interest rates are much higher than those on outstanding debt. This will force an increasing number of owners to take a loss if they are unable to refinance or sell at a sufficiently high price.

While many have wondered when the CRE maturity wall would trigger greater disruption, the reality is that it’s already occurring. This can be seen in the data, such as delinquency rates continuing to rise, as well as in anecdotal accounts of office properties selling at steep discounts to prior sale prices and apartment buildings at discounts to prevailing construction costs. However, a substantial portion of maturing mortgages have been extended, which pushes the recognition of a struggling loan further into the future. Approximately 40 percent of all debt due to mature in 2023 was extended to 2024. If an equivalent proportion of mortgages due in 2024 is rolled into 2025, the result would be $850 billion of CRE debt maturing in 2025, roughly 18 percent of all outstanding CRE debt. Many of those extensions will prove successful and allow the borrower to successfully complete their debt service obligations. But for those that don’t, banks and other lenders will end up owning property for which they will need to find a financial resolution.

So, What’s the X-Factor?

CRE professionals should look forward to the new year, as most data suggests that a recovery is on its way. Stabilizing prices will give way to rising sales volumes, but distress in the capital markets will take longer to resolve and put some downward pressure on the supply of CRE credit. 

However, the recovery will be gradual and slower than many hoped, probably lasting throughout the year. Put more simply, the recovery in the CRE market will begin, but not end, in 2025.