Challenges in Commercial Real Estate

As we look forward to the second half of the year after a sluggish start to 2024, the future hinges on multiple factors. The challenges of an election year, higher interest rates, inflation, and maturing debt loom across an already conflicted market. Election years have always made investors nervous, as the specter of shifting government policies related to taxation, regulation, infrastructure, spending and the residual effects on employment and economic conditions can influence investor sentiment and market dynamics. In addition, factors such as geopolitical tensions and trade disputes can add to the volatility in financial markets, affecting investor confidence and property values. Considering these challenges, many investors opt to wait to make any significant investments until after the conclusion of the election cycle.

Interest rates affect momentum, as markets continue to adjust from covid-level rates to more traditional interest rate levels.  According to CoStar, “Capital markets activity has downshifted significantly, as investors were confronted with an unfavorable financing backdrop and weakening market fundamentals, pressured by subdued leasing activity. While occupancy and rent growth are reverting to pre-pandemic means, sales are further hampered by high debt costs and lower loan-to value ratios.”[1] Property values have diminished as pre-pandemic cap rates are no longer sustainable, while some property owners are finding it difficult to refinance at current rates. There is a direct correlation between interest rates and inflation, as the former is used to control the latter, with rates serving as a mechanism to tame demand and stabilize pricing.

Inflation is a constant challenge for investors, as it can affect property values, financing costs and tenants’ affordability.  Inflation erodes purchasing power, forcing consumers to buy less goods and services with their disposable income and reduces their standard of living.  In turn, investors must adjust to help businesses deal with the slowing demand. Although inflation can hurt business activity, deflation can also be counterproductive as consumers delay making purchases in anticipation of future lower prices. Japan is a perfect example of an economy with limited growth due to deflation.  Ideally, low, predictable and stable inflation is considered the best backdrop for a flourishing economy.

Maturing debt is currently the biggest challenge the commercial real estate market faces: “As $929 billion in loans are set to mature, with an additional $1 trillion anticipated to come due between 2025 and 2026. These maturities represent 42% of the sector’s total outstanding debt.”[2] This poses a risk to already depressed asset classes such as offices and hotels.  In the past few months some of the most iconic office buildings throughout cities across the United States have traded at a significant reduction, and the looming debt overhead will prove problematic if prices continue to fall.

The economic factors affecting the commercial real estate market are indicative of the growing concerns over political and economic stability.   In order to find solutions to these problems, we need to consider unique, aggressive macro solutions such as the creation of incentive programs for banks to allow the restructuring and reclassification of risk assets based on need.  Additionally, incentivizing local municipalities to work with commercial property owners to bring innovative development and redevelopment ideas to their respective towns could spark an economic resurgence at a micro level.

[1] CoStar Northern New Jersey- NJ USA-Industrial-Market-2024

[2] CoStar https://product.costar.com/home/news/1328050268