Private real estate is split on rate cut approach

Amid delayed cuts, some firms continue to model lower borrowing costs, while others have not factored them in at all.

At the end of last year, the outlook for global commercial real estate in 2024 brightened after the US Federal Reserve paused interest rate hikes and signaled the intention to cut rates over the course of this year. But those cuts have so far not materialized, and many in the industry have come to the realization that lower borrowing costs are not a sure bet.

Views on how rates may play out run the gamut in commercial real estate. Some hold on to the hope cuts are still on the Fed’s agenda this year. Others, however, are taking a less optimistic approach.

“At the end of ’23 everyone felt a sense of hope for numerous interest rate cuts in ’24, but as we got into the first couple of months of ’24, people started to realize that their hope was probably misplaced,” said Todd Liker, co-portfolio manager of the real estate opportunities strategy at Los Angeles-based manager Oaktree. “If you look at the short-term interest rate curve in January versus what it is today, you’ll see a marked change in expectations.”

Anticipated near-term rate cuts have reduced by 100 basis points over that period, he noted. “When you consider those who bought properties at 3 or 4 caps, a 100 point swing in interest rate expectations meaningfully changes how you think about carrying costs, hold horizon and value.”

On May 2, the Fed voted to hold rates steady, keeping the benchmark policy rate in the 5.25-5.5 percent range which has been in place since July 2023. Chair Jerome Powell said he expects cuts will still happen, but the “lack of further progress” towards 2 percent inflation was delaying the central bank’s decision. “It is likely to take longer for us to gain confidence that we are on a sustainable path down to 2 percent inflation,” he said during a news conference after the announcement.

But the longer it takes, the worse the problem, according to Richard Mack, chief executive and co-founder of New York-based manager Mack Real Estate Group. He thinks many in the industry are holding on to assets with the view that rates will come down eventually. “People are paying to hold assets, but unless rents rise quickly, eventually asset prices will have to adjust to rates, instead of hoping and anticipating rate decreases,” he said. “In essence you have to pay to wait and see what kind of recovery transpires, which is different from past cycles where interim cashflow paid you to wait for appreciation.”

Other central banks have similarly held steady on rates – at least for now. A week after the Fed vote, the Bank of England also moved to keep rates on hold, although officials hinted cuts may be ahead this summer. The European Central Bank is also widely expected to make rate cuts at its meeting next month.

No ‘bloodbath’ yet

Private real estate groups have taken different approaches to factoring rate cuts into their underwriting. “It is a very, very fickle situation,” said Jordan Slone, CEO of Harbor Group International, a manager based in Norfolk, Virginia. “I wouldn’t say that the sentiment is as strong as it was last fall, [that] there’ll be lots of rate cuts. But it does seem like, for the time being anyway, rate cuts are back on the table.”

Some real estate borrowers got overly excited, he said, as a result of the Fed’s indication of cuts last year – and “were so bold” to take on floating rate financing because they thought rates had hit a ceiling. “That was a risk, and we as a company have not taken that same tack,” he said, adding his firm has been actively reducing its floating rate debt for the last 24-36 months. In 2021, about 36 percent of the firm’s portfolio was financed with floating-rate debt. Today, that is down to 16 percent.

Last December, Slone told PERE that even rate cuts would not be sufficient to “bail out” most people, but in May, he took a more tempered tone. “There are definitely many more foreclosures and workouts that are happening today than there were a year ago,” he said. “But it’s not the bloodbath that some were predicting.”

Other real estate firms, however, are modeling rate cuts for this year, despite the uncertainty over timing. Miami-based BGO, for example, predicts two cuts in the latter part of the year. “I was never in the camp that thought we were going to get five, six – I even heard up to 10 rate cuts this year from some people,” said Ryan Severino, the firm’s chief economist. “That felt like everyone [was] getting too excited in the markets – certainly the futures market getting over its skis based on comments.” He has always expected rate cuts would be slowly and incrementally rolled out.

Largely, the expectation that transaction activity would pick up in anticipation of rate cuts has not played out, with just $71.3 billion worth of US commercial real estate deals in the first quarter of the year, per CBRE and MSCI Real Assets, down 19 percent from a year prior. It is a similar story in both Europe, where $37 billion was traded in the first quarter, down 26 percent from a year prior, according to MSCI data, and in Asia-Pacific, where volume declined by 14 percent year-on-year to $24 billion, according to CBRE.

“I think a lot of people were expecting to jump in more aggressively and because of that disappointment [around rates not coming down], they haven’t up to this point,” Severino said.

Eyes on the opportunity

Not everyone is expecting a cut. Ward Fitzgerald, CEO of EQT Exeter, the real estate arm of Swedish private equity firm EQT, said he is still not expecting lower rates – the same view he has held for 18 months.

“This is because even if the Fed ‘cuts rates’ this would only be short-term rates, and with an inverted yield curve, long rates will stay over 4 percent and borrowing rates near 6 percent,” he said. He thinks values will continue to stay flat while forced sales will accelerate, a scenario he expects will drive more opportunities.

Morgan Stanley Real Estate Investing, the real estate investment arm of the US bank, takes the view that rates will come down over the long term. But co-CEO Lauren Hochfelder said rates have not influenced the types of investments MSREI is chasing, noting her firm’s approach has been to buy in sectors that will perform well.

“In general, we think that when you are overly reliant on the forward curve coming in within a timeframe, you are doing something wrong,” she noted. “You should have durable capital stacks and assets that can withstand higher for longer.”

While industry reactions to rate cuts have been wide-ranging, borrowers taking a more measured approach have opted for a more tempered outlook on rates and have stayed the course on their investment strategy.