As we approach 2024, the multifamily and commercial real estate (CRE) sectors find themselves at a critical juncture. These sectors, integral to the American economy, are influenced by a myriad of factors, including economic conditions, Federal Reserve policies, and evolving market dynamics.
In this article, we investigate the current state and outlook of multifamily and CRE, highlighting their significant impact on lenders navigating short and medium-term expectations from the Federal Reserve. As experts on Wall Street analyze these trends, it's crucial for stakeholders in the real estate and financial sectors to stay informed and adapt to the changing landscape.
Economic and Market Overview
The multifamily and CRE sectors are heavily influenced by broader economic indicators. As of the midyear review of 2023, the CRE market, specifically, has been undergoing notable changes. Investment volumes in this sector are expected to decrease by 37% year-over-year in 2023, but are anticipated to rebound with a 15% rise in 2024. Additionally, the capitalization rate expansion is projected to persist through late 2023, though at a slower pace. This indicates a delayed onset of a recession, pushing the expected peak in overall office vacancy and the bottoming out of average rent to late 2024.
This period is also marked by heightened economic uncertainty for commercial real estate, with key concerns including the Federal Reserve’s influence on interest rate environment and the future of office space. Despite ongoing positive performance in the multifamily and industrial sectors, the real estate industry may have underestimated the resilience of neighborhood retail, highlighting its potential in challenging times.
Moreover, the global economic landscape remains complex, with persistent uncertainties like geopolitical tensions, inflation, and market volatility. Macroeconomic factors such as extreme weather events, population migration trends, and the economic recovery in Mainland China, also impact real estate market dynamics. Despite these challenges, some areas offer clarity and resilience, including proactive policy responses to banking turmoil, stable consumer demand, and stabilized energy and food prices.
As we venture into the latter part of 2023 and look ahead to 2024, understanding these economic and market factors becomes crucial. They not only shape the current state of the multifamily and CRE sectors but also influence the strategic decisions and outlook of lenders and investors in these markets.
Multifamily Sector Outlook
The U.S. multifamily sector remains resilient despite various economic headwinds and disruptions in capital markets. As of 2023, the sector is expected to maintain above-average performance with strong housing fundamentals sustaining high occupancy rates, which are anticipated to stay above 95%. Rent growth is also forecasted at around 4%, a notable figure, although it falls short of the remarkable sub-3% vacancy rates and double-digit rent growth experienced in the previous two years. However, a gradual rise in the national multifamily vacancy rate is expected, rising from an estimated 5.5% at the end of 2022 to around 6.0% by the end of 2023, and slightly higher at 6.25% in 2024.
Despite these promising signs, the multifamily sector is not immune to broader economic pressures. Rising interest rates and the inflated cost of capital raise concerns for investors and developers. These factors result in higher financing costs and tighter underwriting standards by lenders, potentially impacting future development and investment activities.
Commercial Real Estate Sector Outlook
The commercial real estate (CRE) sector faces a more complex scenario as it heads into 2024. The industry’s focus on expense mitigation has intensified, with revenue expectations hitting their lowest since 2018. The primary areas for cost reduction are identified as talent and office space. This trend underscores broader economic uncertainties and concerns about rising interest rates and the cost of capital, both of which are top priorities for industry leaders.
Additionally, the CRE sector grapples with compliance challenges related to environmental, social, and governance (ESG) regulations, with nearly 60% of firms admitting a lack of necessary data, processes, and internal controls. Real estate firms are increasingly turning to outsource for efficiency, with a focus on enhancing technological capabilities and operational agility.
Property fundamentals are expected to worsen, with increased vacancies, reduced leasing activities, and slower rental growth anticipated over the next 12 to 18 months. These challenges are compounded by tightening loan standards, fewer lenders, and higher borrowing costs, making it more difficult for CRE buyers to deploy capital for purchases in 2024.
Amidst these challenges, investment strategies are evolving. Digital economy properties, such as data centers and cell towers, are emerging as top global investment targets. Conversely, traditional sectors like downtown and suburban offices are losing appeal due to the ongoing evolution of work dynamics. Alternative sectors, such as single-family rentals, senior care, and life sciences, are gaining traction, indicating a shift in investment preferences away from the traditional “core four” sectors of office, retail, industrial, and multifamily.
Lender Impacts and Responses
The Federal Reserve's decision to raise interest rates, starting with a 25-basis point hike in March 2022, signaled a significant shift in the commercial real estate landscape. This increase in the federal funds rate, the rate at which banks borrow reserve balances from one another, has a trickle-down effect on consumers, particularly those seeking commercial real estate loans for construction, acquisition, or refinancing. As a result, the cost of capital has risen, leading to widespread ripple effects across the industry.
The Federal Reserve's policy aims to combat inflation, which surged to a 40-year high as of February 2022. Projected increases in the federal target rate, potentially reaching as high as 2.8% in 2023, are part of this strategy. These rising interest rates directly impact the cost of owning real estate by increasing the interest burden on loans. For example, a 2.8% rise in interest rates could add an additional $280,000 per year in interest on a $10 million loan.
In response to these changes, real estate prices may experience a downturn, especially since CRE assets have been trading at peak values in recent years. Transaction activity could slow as buyers and sellers adjust their expectations in light of the higher cost of debt. Additionally, investors may explore other investment avenues if the risk-adjusted returns on CRE fail to sufficiently compensate for increased interest rates. This shift could potentially alter the CRE market, leading to a cooling effect.
Industry Adaptation and Future Strategies
In navigating the challenging interest rate landscape, it’s essential for investors to recognize that the Federal target rate is not the sole indicator. A more relevant factor might be the yields on 10-Year U.S. Treasuries, closely correlated with mortgage rates. Influenced by factors like the stock market and geopolitical events, these Treasury yields may rise further, pushing mortgage rates up accordingly.
Certain sectors, like multifamily real estate, are expected to continue outperforming other asset classes, despite rising interest rates. The consistent housing demand is likely to offset downward pressure from higher mortgage rates. Investors continue to invest in multifamily properties, and as economic conditions improve, landlords may increase rents to counter the higher debt costs. Office, retail, and hospitality properties are also expected to benefit from an overall improving economy.
Advocate’s Summary
As we approach 2024, our analysis of the multifamily and commercial real estate (CRE) sectors reveals a dynamic and intricate landscape. Economic challenges, Federal Reserve policies, and shifting market dynamics create both challenges and opportunities. While multifamily real estate shows resilience with robust housing fundamentals, the CRE sector is adjusting to cost pressures, evolving investment strategies, and compliance challenges.
The impact of rising interest rates, influenced by Federal Reserve measures against inflation, resonates across lending practices, investment decisions, and property values. The real estate industry's ability to navigate these multifaceted changes and uncertainties will be critical for its performance and adaptation in the coming year.