Commercial real estate may be entering a new economic phase in 2025. This period will be dominated by the Federal Reserve’s rate-cutting cycle, and you can expect the commercial real estate market to begin to return to a more normal pattern, including a period of growth in certain sectors.
In 2024, the commercial industry saw private creditors and bridge lenders take center stage during troubled economic times. They were able to accommodate transactions that would not pencil out for conventional lenders, government-sponsored enterprises or commercial mortgage-backed security financing.
For many commercial property owners in need of financing, these deals were, in essence, a “kick the can down the road” approach to their properties. The calculus appeared to be that they could borrow money for a short time until interest rates would fall, making lending look more favorable.
Extend and pretend
Unfortunately, many of these commercial property owners took that position for too long. Those floating bridge loans came to term, forcing landlords to either undertake a “cash in” refinance, which are refinances where borrowers pay lump sums to reduce their balance, or to sell the property to satisfy the existing debt.
Some lenders took an “extend and pretend” approach for certain existing clients and property types to avoid having to show bad loans on their books and extended loan terms to avoid defaults. Both of these approaches kept values propped up in 2024.
Now that the Fed is moving forward with its rate-cutting cycle, there are expectations of increased activity in a variety of segments of the market. Still, expect regional and community banks to tread cautiously.
Banks will continue to place emphasis on owner-occupied commercial properties. Lenders that will entertain investor properties will adopt a minimum depository relationship of 5% to 10% of the loan amount, which can prove prohibitive for some landlords.
Fed expectation
The Federal Reserve should make another 25 basis-point cut in interest rates this month, barring a very strong jobs report or signs of inflation. The Federal Reserve made it clear earlier this year that it was aiming for interest rates to finish 2025 around 3.25% to 3.5%, so expect cuts of about 100 basis points next year. The gross domestic product growth rate appears to be around 2.6% for 2024, but consumers, which make up about two-thirds of the economy, could go into hiding after the holidays, slowing next year’s growth.
For housing and commercial real estate, the question will be how these changes impact U.S. Treasurys, which are the bellwether for mortgage rates. It appears that Treasurys will remain in a 3.5% range next year, which will mean lower borrowing rates.
There is a pent-up demand for homes in the residential sector, but there are potential buyers who are waiting for interest rates and home prices to fall. Don’t expect euphoria next year in the housing market, even with lower interest rates, because home prices will probably remain steady and affordability will continue to be a problem.
Currently, less than 25% of American households can afford a median-priced home. As for renters, apartment rents should continue to drop next year, which will make renting more desirable and put even more pressure on the home purchase market.
Wild cards
One wild card for 2025 facing commercial properties is the exponentially higher operating costs, mainly from property insurance, and whether those costs stabilize or even start to reverse. In 2024 property owners experienced not only higher interest rates but higher fuel costs, insurance costs and — depending on their location — higher electric bills.
“One wild card for 2025 facing commercial properties is the exponentially higher operating costs, mainly from property insurance, and whether those costs stabilize or even start to reverse.”
All these factors made it difficult for properties to qualify for loans. That even included landlords who could charge higher rents in the multifamily sector and hotel owners who were enjoying a rise in revenue per available room from their properties.
Another wild card could be slowing consumer spending in 2025. That would impact multiple markets, including retail, hospitality and industrial sectors. If consumers are spending less, retail and hospitality will experience some challenges and industrial (namely warehouses) will see growth stunted as the need for more industrial space wanes.
A slowing consumer could cause prices to drop across a broad spectrum of the economy. Lower prices would bode well for inflation and future Federal Reserve rate cuts, however.
On top of those wild cards, the recent presidential election will undoubtedly have an impact on the direction of the economy and the future of commercial real estate in the short term and long term. At this point, it is hard to discern exactly what that impact might be.
Office struggles
As for specific commercial sectors, it appears unlikely that there will be a material comeback for office space, aside from a few major U.S. cities, such as New York, in 2025. As of June 2024, the U.S. Office market was suffering from a higher vacancy rate than after the Great Recession in 2008.
It is true that the hybrid work schedules and work-from-home trends appear to be slowly giving way to a return to the norm where workers are required to be in the office most, if not all week long. For instance, Amazon has announced that as of Jan. 2, employees must return to working in the office five days a week. Still, in many parts of the country, including the San Francisco area, Chicago and many of the major metros in Texas, the office sector is in dire shape and may not recover for years to come.
A strong consumer has spurred the construction of a vast amount of industrial space (warehouses) as e-commerce continued to grow. However, for eight consecutive quarters, vacancy rates have been on the rise. If the consumer begins to pull back, this sector could face difficulties. The construction of new industrial property should tail off in 2025, allowing absorption to catch up.
Retail and multifamily
That same strong consumer has allowed retail to make a surprising comeback in many geographic areas around the country in recent years. Look for that sector to stabilize should consumer spending slow down.
The multifamily sector has seen dramatic rent growth since the onset of the pandemic, but that too is beginning to wane. Higher operating and financing costs are stifling net operating income. But an oversupply of apartments on the market will mean rents should continue to drop next year. Should interest rates come down dramatically for residential loans, the multifamily sector may suffer as the pent-up demand for homes will put a strain on the rental market.
● ● ●
Much of this forecast for 2025 assumes the U.S. avoids a recession. And there are dangers lurking. A weakening labor market and the potential for inflation to flare up could disrupt many of these predictions. Still, economists have been saying a recession was on the horizon for the past two years and it hasn’t arrived yet.
The economy has remained surprisingly resilient in the face of higher interest rates and growth should improve with lower rates. Whether unforeseen troubles arise in 2025 or the commercial real estate market begins to return to a new normal, time will tell.
