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Economic Stability Could Lead to Significant Increase In CRE Activity In 2024
Historically, the commercial real estate market has increased or at least maintained its value and overall performance during periods of high inflation. According to a study done by Principal Asset Management, which accounted for notable periods of high inflation throughout history (including the late 1970s and early 1980s), commercial real estate has outperformed inflation 87.7% of the time. Investors in commercial real estate have widely considered the sector to be a long-term hedge against inflation, due to the fact that owners of commercial properties are often able to offset any increases in operating expenses by increasing rents by comparable amounts. The commercial real estate lending market, however, is particularly susceptible to inflation, since, during periods of high inflation, central banks tend to raise interest rates to increase the cost of debt, which, in turn, discourages borrowing and decreases consumer demand. Conversely, when the central banks lower interest rates, the cost of debt becomes cheaper, which results in increased borrowing and higher demand for debt. In the last two years, inflation in the United States has risen to levels not seen since the 1980s. Macroeconomic factors such as supply shortages, geopolitical uncertainty, and low borrowing costs have led to higher commodity costs and inflation. In turn, high inflation has led central banks to continue to increase interest rates, ultimately resulting in high borrowing costs and curbing economic growth.
From 2019 until 2021, particularly in light of the COVID-19 pandemic, the Federal Reserve cut the federal funds rate to generate borrowing and spur economic growth. The federal funds rate sets the range that banks will lend or borrow to each other overnight and directly influences the federal prime rate. The federal prime rate is the rate that banks will customarily charge their most creditworthy customers, and is generally 3% higher than the federal funds rate. During the pandemic, the federal funds rate was near zero. Like other industries, low interest rates stimulated the commercial real estate market significantly, and commercial real estate lending was at an all-time high, with a record $891 billion in loan originations generated in 2021.
However, in an effort to combat high inflation, beginning in March of 2022, the Federal Reserve began rapidly increasing the federal funds rate. Today, the federal funds rate is just over 5% — a massive increase from the near zero rate seen just 18 months ago, and the highest federal funds rate in 16 years. The Federal Reserve rate increases have ranged from 25 basis points to 75 basis points. In March 2023, Federal Reserve Chair Jerome Powell stated that the goal in raising the rates is to bring inflation down to the annual 2% target, implying that the Federal Reserve may continue to increase the federal funds rate until that annual 2% target is met. Over the past year, the total cost of debt is up nearly 300 basis points or 3%. This higher cost of debt has made it increasingly difficult for commercial real estate developers to secure financing within a budget for a particular project, dampening commercial real estate lending and the construction of new developments.
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