Commercial Real Estate Market Cooling from Record High Activity in 2021

By The ArborCrowd Team
Jun 22, 2022

After record transaction activity in the U.S. commercial real estate market in 2021, early signs of a cooling have appeared.

Investors came off the sidelines and funded a record $809 billion in commercial real estate transactions last year as the impact of the COVID-19 pandemic eased. Part of that record result consisted of foreign investors, which returned to the U.S. market and purchased $70.8 billion of assets — the highest total since 2018. The robust activity seemingly continued into the first quarter of 2022 with $170.8 billion in investment sales, which was up 56% year-over-year, according to Real Capital Analytics (RCA). However, the record pace looks to be subsiding.

Investors seemingly became more cautious in April, when U.S. commercial real estate investment sales declined 16% year-over-year to $39.4 billion, RCA indicated. It was the first decrease in 13 months.

While a cooling from a record investment pace was expected at some point, demand for many commercial real estate assets still appears to be strong, especially for resilient sectors, such as multifamily properties.

Rising Interest Rates Play a Big Factor in Investment Volume

Experts have pointed to the Federal Reserve’s interest rate hikes to counter inflation as a primary reason for the real estate investment activity cooling. The rate hikes have resulted in higher mortgage rates and overall increased financing costs for real estate investments.

The Fed began raising rates for the first time since 2018 in March with a quarter percentage point increase to a target range between 0.25% and 0.5%, followed by a half percentage point increase in May. Then on June 15, the central bank issued a three-quarter percentage point hike — the highest in nearly 30 years — to a target range between 1.5% and 1.75%. The Fed is expected to continue increasing interest rates throughout the year until inflation is under control.

Besides increasing mortgage rates, the interest rate hikes have pushed up bond yields, making it an attractive alternative for investors. The 10-year treasury yield recently jumped over 3%, the first time since late 2018. The increased interest rates may eventually drive capitalization rates higher, reducing property values, as investors demand higher returns for the additional risk of real estate investments compared to bonds. So far, however, cap rates have continued to compress, falling 20 to 30 basis points in April for various real estate sectors, according to RCA.

Real estate professionals are assessing the potential impacts to markets, and therefore may not make as many transactions compared to 2021’s high level of activity, but opportunities are still expected to be available.

Opportunities Still Exist Within Commercial Real Estate

A cooling of the commercial real estate investment market is not unusual as the reason the Fed implements rate hikes is to slow economic activity, combating, and ultimately reducing, inflation.

Inflation hit a 40-year high of 8.5% in March, reduced slightly to 8.3% in April, but then increased again to 8.6% in May. The high inflation rate has resulted in extreme volatility in public securities as investor sentiment has changed.

Compared to the stock market, real estate investments are not based on sentiment, but on fundamentals, which remain strong for certain sectors. Multifamily, for example, was one of only two sectors to produce a positive increase (up 7% to $17.9 billion) in investment sales in April year-over-year, according to RCA.

Multifamily rent growth in May fell 40 basis points to 13.9%, but remains far above the 10-year historical average of 2.8%, according to Yardi Matrix’s National Multifamily Report. Also, occupancy dropped 0.2% in May, but remained at an impressive 96%.

Even as the commercial real estate market pulls back from its record pace amid an economic environment afflicted by high inflation, solid real estate opportunities may continue to exist in certain sectors.