The commercial real estate sector has been under intense pressure globally as interest rates have risen over the past couple of years. In the US, with the largest commercial property market in the world, prices have tumbled by 11% since the Federal Reserve (Fed) started raising interest rates in March 2022, erasing the gains of the preceding two years.
Higher borrowing costs tend to dampen commercial property prices directly by making investments in the sector more expensive, but also indirectly by slowing economic activity and reducing the demand for such properties. Nevertheless, the sharp decline in prices during the current US monetary policy tightening cycle is unusual. As the chart below shows, contrary to the current policy cycle, commercial property prices remained generally stable or saw milder losses during past Fed rate hikes. Some of the earlier rate hikes, though, such as in 2004-06, were subsequently followed by a recession during which commercial property prices recorded notable declines as demand fell.
Source: International Monetary Fund (IMF)
Part of this divergence in price behaviour between the recent and past monetary policy tightening cycles may be attributed to the steep pace of monetary policy tightening this time around, a factor that has contributed to the sharp increase in mortgage rates and commercial mortgage-backed securities spreads.
The effects of tightening financial conditions on commercial property prices over the past two years have been compounded by trends following the pandemic, such as teleworking and e-commerce, that have led to far lower demand for office and retail buildings and pushed vacancy rates higher.
These challenges are particularly daunting as high volumes of refinancing are coming due. According to the Mortgage Bankers Association, an estimated $1.2 trillion of commercial real estate debt in the US is maturing in the next two years. Around 25% of that is loans to the office and retail segments, most of which are held by banks and commercial mortgage-backed securities.
Prospects for the sector remain challenging, even as central banks signal that interest rates may have peaked and investors grow more optimistic about a soft landing for the economy.
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