In this episode of The REconomy Podcast™ from First American, Deputy Chief Economist Odeta Kushi and Senior Commercial Economist Xander Snyder turn their crystal ball to the commercial real estate market, breaking down the outlook for 2025 for all asset classes.
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Listen to the REconomy Podcast™ Episode 105:
“Data from the Mortgage Bankers Association indicates that commercial real estate mortgage origination activity increased by nearly 60% in the third quarter compared to a year ago. Though it's worth keeping in mind that that growth in origination activity is off of a very low number from last year. By comparison, the second quarter of this year, growth and originations were also up, but only by about 3%. So, more loans being made means that lenders are willing to lend, which suggests that more lenders are becoming comfortable with commercial property valuations that are used as collateral for their loans.” – Xander Snyder, senior commercial economist at First American
Transcript:
Odeta Kushi - Hello and welcome to episode 105 of The REconomy Podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Xander Snyder, senior commercial economist. Hey Xander, welcome.
Xander Snyder - Hey Odeta, how did we get to the end of 2024 already?
Odeta Kushi - The year really has flown by, hasn't it?
Xander Snyder - Yeah, it sure has. And that, of course, means it's time to look ahead to 2025.
Odeta Kushi - Have you dusted off your crystal ball for this episode, Xander?
Xander Snyder - I did, but no matter how thoroughly I clean my crystal ball, it always looks a little hazy. Do you run into that same problem with yours?
Odeta Kushi - I see that the issue is that you didn't spring for the high-end crystal ball cleaner.
Xander Snyder - That must be the problem. I cheaped out and now as a result I have a budget forecast. Get it?
Odeta Kushi - Yeah, unfortunately, I do get that pun.
Xander Snyder - Okay, puns aside, the last two and a half years have been a challenging period for commercial real estate. And everyone's been looking for signs that this adjustment period that we've been living through is finally coming to an end. So, in this episode, we'll take a look to see if those signs are approaching in 2025.
Odeta Kushi - Yes, 2025 has certainly been a year that many in the CRE world have been looking forward to for some time. Even the now infamous phrase, stay alive until 2025 has been coined about it. At this point, 2025 is nearly here. So, the stay in alive bit has either been largely pulled off or not, depending on the business. As far as I know, though, you were the first to coin the phrase stay in the mix until 2026. Stay in the mix until 2026, rather, if that gives readers any sort of indication about what you think the pace of the recovery will look like next year.
Xander Snyder - My knowledge, yes, though now it appears that phrase has caught on everywhere, which is a good thing.
Odeta Kushi - You know, the telltale side of a great expression is its ability to resonate and catch on. So well done there. But, what did you mean by that? How will 2026 differ from 2025?
Xander Snyder - Well, what I meant is that I think 2025 will be the year that a recovery begins in earnest, but that recovery will be gradual and it'll take place throughout the year and may be a slower process than many have been hoping for. It certainly has been to date with interest rate-related fits and starts, but 2026 will be the year I think when the market really begins to be more robust again.
Odeta Kushi - So, in other words, the recovery will begin but won't end next year. So, if we expect a recovery to start next year, what exactly does a recovering commercial real estate market look like?
Xander Snyder - Well, I think when you look to the sales market, a recovery implies first that price declines end and two, that transaction activity begins to increase. So, on the pricing side, we appear to be on the cusp of prices stabilizing, at least for most asset classes.
Odeta Kushi - Well, moderating price declines is certainly reason to be cautiously optimistic. Is that the case for all asset classes?
Xander Snyder - Well, in the case of industrial properties, prices have been increasing on an annual basis actually already for the last year. Prices for most other types of asset classes are still declining, but at a more moderate rate than about a year ago. And lastly, prices for urban offices are still declining at double-digit rates. They're the outlier.
Odeta Kushi - Yeah, that's the challenging asset class right now. So, we've talked about where commercial property prices are heading, but what about trends in transaction volumes? Prices and transaction activity are, of course, closely related. If a lot of market participants disagree about what commercial properties are worth, then fewer transactions will take place since buyers won't be willing to offer a price that sellers want. This is the dynamic that's prevailed over the last two and a half years and has led to some of the slowest purchase activity since the aftermath of the Global Financial Crisis. By contrast, if price declines and moderate price increases begin next year, that would be a sign that more people in the market are agreeing on what commercial properties are worth in this higher interest-rate environment. Gradually increasing prices would also signal demand steadily returning to the market.
Xander Snyder - Yeah, I think that's exactly right. The convergence in price expectations between buyers and sellers that you just described points to what I think will be a really important part of the commercial real estate recovery. Many have been waiting with baited breath for interest rate cuts, thinking that once rates finally start coming down, everything will turn back around and be peachy. But the recovery will not just be an interest rate story. Yes, interest rates will play an important role because lower rates means cheaper acquisition financing that can boost demand to own and purchase commercial properties. But more people agreeing on what properties are worth, which has really been the largest disconnect over the last two and a half years, will also drive up transaction volume. The price story, I think, this convergence in price expectations is what will really drive the recovery next year.
Odeta Kushi - So, when commercial property price declines stop or reverse, that'll be a sign that the gap in price expectations between buyers and sellers has narrowed or reversed. Will this happen next year?
Xander Snyder - I think the answer to that is yes. And first, just to be clear, a substantial amount of price discovery has already occurred over roughly the last year and a half, two years. But, if the current moderation in property price declines continues at the current rates, then growth in commercial property prices for most asset classes would occur by the end of next year, positive growth.
Odeta Kushi - And, as a little side note here, if you check out the latest X-Factor blog post from December on the First American Economic Center, you can see a chart showing when commercial property price growth would turn positive for each asset class based on the current rates of moderation.
Xander Snyder - Right, exactly. And the reason I'm emphasizing prices as central to the recovery is that you can make a commercial real estate deal pencil out. You can make it work, even if that deal has expensive debt. So long as you buy the property cheaply enough and don't use too much debt. With prices down so substantially compared to several years ago, even if rates don't, even if interest rates don't fall as much as the market is currently hoping, I still expect transaction volumes to increase because more buyers and sellers will find agreement on prices.
Odeta Kushi - Have sales volumes already begun to turn around given the moderation and price declines?
Xander Snyder - Not quite yet, but it does seem like sales volumes have bottomed out. On a trailing 12-month basis, sales transaction volumes hovered around $300 billion for the last four quarters as of the third quarter of 2024. And, while that's still about 30% below the five-year pre-pandemic average, the fact that volume hasn't fallen below this level in over a year in this high interest rate environment suggests that a bottom has probably been reached in terms of sales activity.
Odeta Kushi - Interesting. So, let's switch gears a little bit here. Let's turn our attention from the sales market to the refinance market. Do we see a similar trend refinancing volumes bottoming out as price declines moderate?
Xander Snyder - Similar, yes, but I'd argue that the refinance market paints even a slightly more optimistic picture than the sales market. So, similar to sales volume, refinancing volumes fell substantially when interest rates began to increase in 2022. But in the third quarter of this year, refinancing volumes increased on an annual basis for the first time since the second quarter of 2022 by about 20%.
Odeta Kushi - It's interesting that refinancings have picked up sooner than sales, especially since the Federal Reserve's first rate cut didn't occur until the very end of the third quarter of this year. So what's causing that rebound?
Xander Snyder - Well, like in the residential market, commercial refinancings are even more sensitive to interest rate changes than purchases. When you're contemplating refinancing a commercial property, there isn't a property price to be negotiated with a seller, only an appraised value that the lender has to sort of generally agree on. You don't need to get to an exact number. So, if a lender and borrower agree on the ballpark valuation of what that property as collateral is worth, then the consideration from the owner's side becomes really exclusively about can I get a lower rate with a new loan than what I currently have.
Odeta Kushi - It's also worth mentioning that although short-term rates didn't begin to fall until the end of the third quarter, long-term rates fell earlier in the quarter. The 10-year treasury is usually the benchmark rate that lenders reference when considering whether or not to extend new commercial real estate loans, and it declined from about 4.4% in June to a trough of 3.6% in September. It has since rebounded and now sits at about 4.2%.
Xander Snyder - Right, and borrowers who were able to take out a fixed-rate loan in that period when the 10-year was down below 4%, they've locked in a lower cost of capital, even though the 10-year Treasury yield is now back up above that 4%, around 4.2%.
Odeta Kushi - If higher commercial refinancings in the third quarter were in part driven by this period of lower long-term interest rates, does this imply that the uptick in refinancing activity that we saw in the third quarter won't continue in the new year if rates remain high?
Xander Snyder - That's a good question. Refinancing activity will depend, at least in part, on how interest rates, both long-term and short-term interest rates, move. But the fact that lenders are also becoming more comfortable with asset valuations in a higher interest rate environment, in addition to buyers and sellers, this will provide a tailwind to refinancing activity even if rates remain elevated.
Odeta Kushi - That's a really good point. I mean, think about it from the lender's perspective. There's only so much profit that can be earned from a loan, its interest rate. But the downside could be total if the borrower stops paying you back. Lenders, therefore, want to be as confident as possible about the true value of their collateral. When prices are falling quickly, this is difficult to do. But with broader agreement and asset valuations, we should expect to see greater refinancing activity, even if the 10-year treasury remains near where it is now.
Xander Snyder - Right. And one data point that I think supports this line of reasoning is the increase in commercial real estate loan originations in the third quarter of this year. So, data from the Mortgage Bankers Association indicates that commercial real estate mortgage origination activity increased by nearly 60% in the third quarter compared to a year ago. Though it's worth keeping in mind that that growth in origination activity is off of a very low number from last year. By comparison, the second quarter of this year, growth and originations were also up, but only by about 3%. So, more loans being made means that lenders are willing to lend, which suggests that more lenders are becoming comfortable with commercial property valuations that are used as collateral for their loans.
Odeta Kushi - Well, that's good news. So, we've talked about what a recovery would look like from the perspective of buying and refinancing properties. But what about the leasing market? What can we expect in terms of tenant demand in 2025?
Xander Snyder - Well, course, the appropriate caveat about there being a variation across asset classes, but let's take a quick tour of leasing demand by asset class. Leasing demand for apartments has actually ended the year stronger than many anticipated, but there are still a lot of new apartment units coming to market next year. So, from a renter's perspective, this is a tailwind since it provides them with choice and potentially lower rents, at least in certain markets. That supply though, that new supply of apartment units coming to market is a near-term dynamic since apartment construction starts have since fallen fairly dramatically. So, when we reach 2026, there will be substantially less new supply coming to market.
Odeta Kushi - So, if that's a near-term dynamic, then a longer-term dynamic is the housing shortage that we still have at a national level, even after accounting for all the new supply.
Xander Snyder - Yeah, and as a result, I imagine that any downward movement in rents that the new apartment supply causes won't last forever in most places.
Odeta Kushi - And, interestingly, it seems like there's some similarities between the multifamily market and the industrial market, right? Lots of new supply coming on in the near term, but construction starts falling and strong long-term leasing demand fundamentals.
Xander Snyder - Yeah, that's exactly right. There's substantial new industrial supply that's come to market recently, and that's going to put downward pressure on rents, again, in certain geographies. But the long-term drivers demand for industrial space – the rise of e-commerce, the ongoing need for advanced logistics capabilities, data centers – all of these trends are not going anywhere soon, and they're the major drivers for demand for industrial space.
Odeta Kushi - That's right. So, what about retail properties?
Xander Snyder - Well, retail properties have a bit of a different dynamic. So, though consumers are still spending money, they're also racking up more credit card debt with increasing delinquency rates. So, there's a real possibility that retail sales slow in the back half of next year. However, there's almost no retail space coming to market, almost no new retail space and very little existing retail space that's currently out there available to rent. So, this limited availability of retail space will likely act as a floor on retail rents, even if these headwinds to consumer spending materialize next year.
Odeta Kushi - And we have to, of course, talk about the office market. Will they continue to be an outlier in terms of performance?
Xander Snyder - I think that on average that statement is true. From a renter's perspective, that means that there will be lots of space available to rent, which will let prospective renters get good deals from landlords. But it's worth keeping in mind that you can have an asset class underperforming on average, market level, national level, and still have individual office properties that are 90-plus percent occupied. So, both of these things are true right now at the same time.
Odeta Kushi - Sort of like that economic proverb about the six-foot tall man who drowned crossing a river that was five feet deep on average.
Xander Snyder - Yeah, exactly. That's one of my favorite lines, by the way. But I think one thing worth mentioning about office that I do think is distinct from the other asset classes that we just ran through is that this adjustment period for office space has not just been cyclical, which is to say it's not just been a price story. So, less office space is needed now compared to pre-pandemic, which isn't really the case with other asset classes.
Odeta Kushi - Yeah.
Xander Snyder - So, as a result of that, I do think that the adjustment period for office properties, especially urban offices, will last longer than for other asset classes and will last beyond 2025 as tenants continue to discover how much space they really need.
Odeta Kushi - Well, there you have it folks, a new year that deserves some cautious optimism. And I should mention before I let you go, Xander, that I think we may have broken Mark's REconomy 1980’s references streak. No, it's okay. He'll have something to say about it, but I think that means that he can start fresh in 2025 and start a new streak. So, it's actually, it's good news, right?
Xander Snyder - Oh no! What have we done?
Odeta Kushi - Thanks, Xander. And a very happy holiday season to all of our listeners. Thank you for joining us on this episode of The REconomy Podcast. If you have an economics-related question you'd like us to feature in the future, you can email us at economics@firstam.com. And, as always, if you can't wait for the next episode, you can follow us on X. It's @OdetaKushi for me and @XanderSnyderX for Xander. Until next time.
Thank you for listening, and we hope you enjoyed this episode of The REconomy Podcast from First American. We're pleased to offer you even more economic content at firstam.com/economics. This episode is copyright 2024 by First American Financial Corporation. All rights reserved.
This transcript has been edited for clarity.
