Executives behind some of the nation's largest office landlords say the long-awaited move by the Federal Reserve to trim interest rates will make it easier to take their foot off the brake when it comes to making deals, propelling a recovery for the hard-hit sector. But even with the larger-than-anticipated cut, not everyone is prepared to step on the gas.
"As the Fed starts to cut rates, that will signal the upward pressure on rates is over, and at least give some visibility on where the economy is going," Brandywine Realty Trust CEO Jerry Sweeney told CoStar News.
Interest rate cuts kicked off this week with an initial reduction of 0.5%, and more cuts are expected at each of the Fed's meetings through at least 2025, according to Oxford Economics. While such cuts are expected to help loosen capital markets and make it easier to finance deals, real estate professionals said, they are just a piece of what will likely be a long road for the office market's post-pandemic recovery.
The Fed began raising interest rates in early 2022 in an attempt to cool an overheated job market and a record spike in inflation. Rates jumped 11 times between March 2022 and July 2023, ranging between 25 to 75 basis points each time. That pushed the federal funds rate up to as high as 5.5%.
For the commercial office market, which has already spent the past several years fighting against record-high vacancy rates and evaporated demand as a result of the pandemic, the spike in interest rates made it even harder for landlords to figure out how to best move forward.
Sweeney said he'll be paying attention to the Fed's commentary moving forward to decipher whether "there's a high degree of confidence that we're on a path of programmatic rate reductions. That will be an extraordinarily positive message to the real estate capital markets. It's about how they view the landscape for the immediate term."
Deals loom
Across the United States, office valuations have collapsed under the impact of flexible work trends, depressed leasing volume, bleak refinancing conditions and high interest rates. The fall in office values could match or surpass the depreciation reported throughout the Great Recession, credit rating agency Fitch Ratings wrote in a recent report, adding that prices have yet to bottom out.
Average pricing is down about 40% since the end of 2021, according to CoStar data. Valuations will likely face more turbulence over the next year to 18 months as a string of low-rate loans mature and higher rates trigger the need for repricing.
For some of the largest office real estate investment trusts, the cuts mean more firms "will be able to go on the offensive," Kevin Shannon, Newmark's co-head of U.S. capital markets, told CoStar News, a marked turnaround after years of holding off on major acquisition and development decisions.
With higher rates, a number of investment firms have had to hold back capital in order to cover debt maturities, Shannon noted. Yet even ahead of the announced cuts this week, larger REITs such as Hudson Pacific Properties and BXP have prepared to ditch their spot on the sideline.
Los Angeles-based Hudson paid $43.5 million in April to buy out its partner for a San Francisco office building that used to house the headquarters for Uber and technology company Block.
What's more, debt portfolios for landlords such as BXP are "going to see a real benefit" from declining rates, according to Mike LaBelle, chief financial officer of the Boston-based REIT.
"Our stock price has gone up over the last three months, and part of that is the view of interest rates coming down and the benefit that will have on valuations and interest costs going forward," LaBelle said. About 10% to 15% of BXP's debt portfolio — valued at roughly $1.8 billion — is floating rate, he added, clearing the way for green shoots as rates decline.
Long road to recovery
Even with the reduction in capital costs, REIT executives said the days of pre-pandemic acquisition and development activity are unlikely to return in full force.
The national office market is still contending with a depressed leasing environment that has pushed the average vacancy rate up to nearly 14%, according to CoStar data.
What's more, a broad range of office tenants across the U.S. continue to adjust their real estate portfolios to adapt to a pandemic-era reality in which they don't need as much space.
Tenants collectively signed on for about 395 million square feet last year, according to CoStar data, about 13% below the annual average reported in the years leading up to the pandemic's 2020 outbreak. Those deals are about 16% smaller on average than those signed between 2015 and 2019, exacerbating the vacancy challenges and onslaught of available space littered across the country's largest office markets.
"Removing the overhang of where rates will peak is extremely important, but I don't think you'll see a huge swing in activity" in the first few days after rates are cut, Brandywine's Sweeney said. "There are still a lot of variables that will take a number of years to shake out."
For starters, the market is still weeding through a significant amount of older office properties that "are functionally not competitive and, from a consumer standpoint, functionally obsolete."
So even though the cost of acquiring those properties will be far lower than previous price tags, Sweeney said, much of that inventory will need to be repurposed or demolished to be worthwhile investments.
"We have put some options out for price discovery and, as we get bids in for properties, we take a hard look at them. I may not like the pricing, but the numbers tell you differently," Sweeney said.
As for new construction, the pipeline for office developments has all but dried up as a majority of developers remain hesitant to invest in any major projects unless they're significantly preleased or built to suit.
Back from the sidelines
Despite any lingering uncertainty about the office market's future trajectory, the loosened financing climate is enough to at least lay the groundwork for improvements ahead, stakeholders said.
Smaller lenders and community banks, for example, have kept their distance in terms of funding any office real estate-related projects, Newmark's Shannon said, a stance he expects will change as a decline in interest rates prompts some to take a more active approach to financing deals or projects.
"When rates go up as fast as they did in 2023, it's a disaster," he said. "When capital doesn’t know what the cost of capital is, capital pauses. At every meeting we had last year, it was nearly impossible to get capital off the sidelines."
For the remainder of the year, Shannon said he's expecting transaction volume to gain speed, especially as office owners come to terms with the new valuation landscape. Already the bid-ask spread, or the gap between what buyers are offering and what owners are willing to accept, is shrinking, a trend that should only continue as rates head lower.
Already, large institutional players such as BXP have been evaluating potential acquisitions and beginning to price them out, a step many have until now been hesitant to make as valuations continued to drop.
"Obviously the data points aren’t pretty, but there’s more acceptance about the values of office," Shannon said. "That's a sign the healing process has started."