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Charleston Business

Signs of a Recovery

Sep 26, 2024 03:32PM ● By David Caraviello
(123rf.com image)

By David Caraviello

The commercial real estate market is beginning to emerge from one of the worst down cycles it’s experienced since the Great Recession, according to economists. But the level and speed of recovery will vary depending on sector, so it’s not quite time to pull out the balloons and party horns just yet.

But the Federal Reserve’s move on Sept. 18 to trim the benchmark interest rate by 50 basis points — its first cut in four years, and its biggest in 16 — heralds the beginning of a softening monetary policy that lays the groundwork for a commercial real estate recovery, Wells Fargo economists said in a presentation Wednesday. More rate cuts are anticipated through the summer of 2025, improving the environment for lending and coaxing capital off the sideline.

“The Fed cut rates by 50 basis points last week, and we expect them in the coming quarters to continue to cut rates,” said Jay Bryson, managing director and chief economist at Wells Fargo Corporate and Investment Banking. “And so, by the middle part of next year, we think the Fed funds rate will be down about 3 percent or so in aggregate. Including last week, we're looking at over 200 basis points of easing.”

Overall conditions in the commercial real estate market — some sectors of which have been struggling since the pandemic — have deteriorated since early 2022 when the Fed began raising rates in an attempt to tamp down inflation. The result in commercial real estate was a sizable drop in transactions, higher capitalization rates, lower property values, and a reduction in lending. Combine that with a surge of new construction post-pandemic, and the result was higher vacancy rates and slower rent growth across many property types.

“Commercial property prices across the board, have, for the most part, declined sharply over the past two years,” said Charlie Dougherty, director and senior economist at Wells Fargo Corporate and Investment Banking. While the degree of decline varied due to asset class — multifamily down 8 percent over the past year, industrial down 9 percent, office properties in central business districts down 27 percent — just about everyone felt the pain.

“A lot of these sharp declines have occurred over this period of tight monetary policy,” Dougherty added. “So as the Fed starts to ease and bring down rates, that should benefit property valuations. You're already starting to see the positive impacts in terms of long-term rates. In anticipation of easier monetary policy in the future, you've had things like the 10-year treasury yield already start to come down a little bit. You're already starting to see cap rates move sideways or even move down a little bit. Capital flows are another important driver, but even there, you're starting to see some strengthening.”

Office ‘a different story’

The caveat to that brightening macroeconomic picture is the fact that conditions can differ within individual commercial real estate sectors. For instance, while “the fundamentals here are saying that things are still holding up fairly well,” Dougherty said, “of course, the office market is a different story.” Office transactions are down about 5 percent over 2023, he added, and down 34 percent from the pre-pandemic days of 2019. “You're down across the board, across most major property types. There's very little sales activity still happening.”

An easing of monetary policy should help improve transaction volume, Dougherty added. But then there are the rising delinquency rates for office properties, which have increased 5 percent  since the pandemic. “There's very likely to be some more stress that occurs in the office market, especially when considering that a lot of the leases that were signed before the pandemic have yet to roll over,” he said. “The trend there is still pretty weak in terms of demand falling well below supply.”

So, where’s the recovery? For the office sector, Dougherty said, it should begin with the fact that a less-rigid monetary policy will make it easier to refinance debt, and make lenders more amenable to extending or amending troubled loans. Some banks have had restrictions on commercial real estate lending in place since early 2022, he added, and while they continue to be cautious, lower Fed rates should also make them less guarded in their approach.

The office sector isn’t the only area where supply has outpaced demand. That’s also evident in the industrial market, where the vacancy rate has risen 3 percent over the last two years. In South Carolina, statewide industrial vacancy stood at 10.66 percent in the second quarter of 2024 compared with 6.33 percent one year earlier, according to a report by the commercial real estate firm Colliers South Carolina.

But unlike the office market, which continues to be hamstrung by the work-from-home movement, industrial is showing positive signs in terms of rent growth and demand. E-commerce is spurring a steady demand for warehouse and distribution space, and data center construction has surged 60 percent year-over-year, according to Wells Fargo. In South Carolina, industrial vacancy is likely to peak in the near term, according to Colliers, mirroring the national market.

“There's reason to believe that things are improving and demand may have bottomed out,” said Jackie Benson, vice president and economist at Wells Fargo Corporate and Investment Banking.

Declining retail vacancy 

In the multifamily sector, demand is beginning to catch up to a surplus of supply, and rents have stabilized, likely due to escalating home-buying costs — made more burdensome by higher mortgage rates, which tacked on thousands of dollars to the price of purchasing a home. Hotel growth has been concentrated on luxury and upscale brands, Benson said, reflecting increased travel from business travelers and high-income spenders.

And in the dogged retail sector, Benson said, is the only major commercial real estate class where rent growth remains above pre-pandemic levels. “Most segments are experiencing declining vacancies, notably neighborhood centers and strip centers,” she added. The glaring exception is regional malls, which continue to be the weakest segment of commercial real estate.

Those retail trends are reflected in South Carolina, which according to Colliers recorded near record-low vacancy rates statewide in the second quarter of 2024. The retail vacancy rate in the Palmetto State was 3 percent, and in some markets — notably Charleston and Myrtle Beach — it was even lower than that. In the fourth quarter of 2020, in the depths of the pandemic, the statewide retail vacancy rate was 6.3 percent.

Now that sounds like a recovery, even if the main factor curtailing vacancy is a dearth of retail construction starts, which according to Wells Fargo are currently at their lowest level since CoStar began tracking them in 2007. But retail demand “is still firmly positive,” Benson said. “You know, brick and mortar sales may not be growing as fast as e-commerce, but at least to date, they're still growing.”