By Despite the recent surge in interest rates, the U.S. economy remains resilient. However, the same cannot be said for commercial real estate prices. In the aftermath of the pandemic and the Federal Reserve’s fight against inflation, prices have experienced a decline. Morgan Stanley analysts predict that while some of the pain has already been felt, there is still more to come.
As of May, prices for apartment buildings, office properties, and retail centers were down approximately 8% to 14% from their peak levels (see chart), which falls slightly below Morgan Stanley’s initial estimates (blue line).
Unfortunately, property owners should brace themselves for further declines. Morgan Stanley’s REIT research team, led by Ronald Kamden, reiterates their forecast of a peak-to-trough price drop of 27.4% for all commercial property types by the end of 2024.
Comparatively, this drop is less severe than the 34.9% experienced during the global financial crisis about 15 years ago. However, it’s worth noting that prices rose nearly 150% in the subsequent period leading up to the pandemic, according to Morgan Stanley data.
While price decreases have been observed across the board, retail, industrial, and office properties in both suburban and central business districts are expected to bear the brunt of the decline. The REIT research team explains that transaction activity and distressed sales will likely contribute to this trend.
Implications for Office Buildings
Office buildings in major U.S. cities, particularly those located in financial districts, are projected to face significant challenges. Hybrid work arrangements, tighter credit conditions, and higher interest rates are expected to take a toll on these half-empty buildings.
Notably, New York magazine recently highlighted how big Manhattan office landlords are seeking to offload buildings that have decreased in value.
The Impact of COVID-19 on Office Buildings and Real Estate Market
The COVID-19 pandemic has significantly affected the demand and prices of office buildings, according to a report by the McKinsey Global Institute. In the hardest-hit cities, demand for office buildings could plummet by as much as 38% compared to the levels in 2019. The report also predicts that office prices will experience a decline of approximately 26% on average in a moderate scenario, but a more severe scenario could lead to a plummet of 42%.
The pressure felt in the office sector is expected to “spill over” into other property types, such as hotels and retail. The challenge lies in the difficulty of refinancing, which could impact these sectors as well. Hotels, for instance, may face a headwind in generating revenues if airlines continue to face elevated costs, flight cancellations persist, and corporate travel remains limited due to cost-cutting measures.
Despite the challenges faced by the real estate market, the Dow Jones Equity REIT index has shown some resilience. It experienced a 3.1% increase on a year-to-date basis through Monday, as reported by FactSet. Stocks have rallied in 2023, reflecting the strength of the U.S. economy, despite the Federal Reserve’s decision to raise interest rates by approximately 500 basis points to a range of 5%-5.25%.
Federal Reserve officials have indicated that two more rate hikes could take place this year, with another 25 basis point increase expected in the upcoming month. As of Monday, the S&P 500 index had increased by approximately 17.8% since the beginning of the year, while the Dow Jones Industrial Average showed a 4.3% increase and the Nasdaq Composite Index recorded an impressive surge of 36%, all according to FactSet data.
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