Extend and pretend

With the elections now over, that element of uncertainty is resolved, but it remains to be seen how the policies of the incoming administration will affect the economy, and real estate in particular. This apprehension is why Treasury bond pricing is high at 5%, and why the term premium mortgage holders expect is still at a wide spread by historical standards.

The 30-year fixed rate residential mortgage is now 7%. Commercial rates are even higher, ranging up to 10%. The Federal Reserve has been conservative about further interest rate reductions: investors who were relying on significant rate cuts in 2024 were disappointed and that will not change for 2025. “Higher for Longer” is a fact of life going forward. Commercial asset prices have started to decline, and sales have slowed in this environment. Sellers don’t want to take a loss unless they have to, but some sellers are looking at costly re-financing when existing loans come due, or costly upgrades to properties to stay competitive for tenancies.

Insurance rates are astronomical and property taxes have risen to the point simply holding an asset has become much more expensive. Cap rates are slowly rising: buyers are wary of overpaying for assets with acquisition interest rates that are higher and economic growth that is not certain. Motivated buyers are cautious: even with a 1031 exchange that defers the capital gains tax, the savings may be only 15% depending on the purchaser’s tax bracket, which does not move the needle enough to justify the investment. There’s about $1.8 trillion in commercial real estate loans that is set to mature over the next two years.  Lenders prefer to extend the maturities, in the hope that economic conditions will improve enough to make these loans recoverable. Eventually though, banks will require more capital reserves to continue holding these loans. Buyers who purchased at cap rates of 4 or below are now facing debt service payments 100% higher than their original loan. As values re-set at lower levels, maturity balances may be too high to refinance. 

There’s a lot of capital on the sidelines watching intently for opportunities as weaker operators who are not well-capitalized are forced to divest. As forced sales proceed, this lowers the cost base for those assets, which can then accept lower rents, creating a ripple effect that brings down values overall. Not all property types have been affected to the same degree: industrial buildings and flex space have held close to their lofty valuations, whereas office towers not so much. Data centers and newer sophisticated self-storage facilities are also in strong demand and have held up well. Grocery-anchored strip mall retail centers and strong covenant single-tenancy properties are still trading in the mid-6 cap rate range. The soft spots are in older projects with deferred maintenance issues, in secondary locations. Multi-family cap rates have started to weaken in certain metro areas.

Over the past five years, this sector had been the darling for investors, and developers/syndicators rushed to satisfy demand from both renters (many of whom could not afford to be homebuyers) and investors. The rent vs. own calculation still favors renting in many jurisdictions, but there is finally a surplus of new product that has come to market, putting pressure on rents and investment transactions. Barring some black swan event (always a convenient out for prognostication) 2025 will continue the process of letting the steam out of the asset bubble build-up from so much liquidity injection over the past six stimulus years. I’m not really that hopeful fiscal sobriety will all of a sudden hit Washington, D.C., but as my friend Warren Buffett says “when the tide goes out you can see who’s been swimming naked.” 

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Raphael Barta is an Associate Broker with an active practice in residential, vacant land, and commercial/industrial properties (Raphaelb@sandpoint.com).