At the heart of commercial real estate (CRE) is the matter of money: who has it, who gets it, and what’s a reasonable balance between risk and reward? There’s no single answer to such questions, but there is a financial yardstick that reflects what the marketplace thinks, the 10-year Treasury yield.

“The conventional wisdom,” according to The New York Times, “is that U.S. Treasuries are the safest bonds, a claim that has given them an exalted status as the benchmark from which all other asset values may be measured. The ‘risk-free’ rate provided by Treasuries is used in finance as the hurdle that every other investment — a stock or a capital project or a buyout of a private company — must clear to be deemed even minimally viable as a place to put your money.”

Whichever way 10-year Treasury yields move can greatly impact CRE values and returns. And, as it happens, the 10-year benchmark was much in the news in 2023 — and no doubt will be closely watched in 2024.

Both Fitch Ratings (August) and Moody’s Investors Service (November) lowered their US government securities ratings in 2023, something that’s happened only once before, when Standard & Poor’s dropped the ratings hammer in 2011. However, these downgrades are similar to an exceptional residential mortgage borrower whose credit score falls from a flawless 850 to something lower, perhaps 847. While 847 is still remarkably high, it just isn’t 850, it breaks the illusion of financial perfection and risk-free lending.

Commercial Real Estate and The Federal Reaction

According to Moody’s, the federal government needs to reduce spending or increase revenues, otherwise its “fiscal deficits will remain very large, significantly weakening debt affordability.”

Steeper Treasury rates mean the government must spend more to finance the $26 trillion in debt it has outstanding, a cost that can lead to bigger budget deficits, program cutbacks, and inflationary pressures. Alternatively, if the government cannot pay its debts, the results can be worse.

“For decades,” said The New York Times in June 2023, Treasury bonds “have been viewed as the ultimate safe asset — the bedrock of the global financial system. But as the deadline for an agreement to avert a U.S. debt default loomed, Treasury bills due in early June were priced as the near equivalent of junk bonds.”

What Happened When Treasury Rates Rose?

Lower ratings mean more risk, higher yields, and steeper mortgage costs. Ten-year Treasuries ended 2019 at 1.90% and reached 4.98% in October 2023, the highest rate seen since 2007. The rate quickly retreated and was down to 4.42% by Thanksgiving, and 4.12% as of December 6, 2023.

These changing rates and what they imply haven’t gone unnoticed. In June, The Fed, the Office of the Comptroller of the Currency, the National Credit Union Administration, and the FDIC — issued a joint “Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts.”

“The agencies,” said the 90-page document, “encourage financial institutions to work proactively and prudently with borrowers who are, or may be, unable to meet their contractual payment obligations during periods of financial stress. Such actions may entail loan accommodations that are generally short-term or temporary in nature and occur before a loan reaches a workout scenario.”

Workout options, said the regulators, “can take many forms, including a renewal or extension of loan terms, extension of additional credit, or a restructuring with or without concessions.”

According to the Federal Reserve, the delinquency rate for CRE loans held by banks was 0.68% at the end of 2019, just before the pandemic’s onset. As of the third quarter of 2023, the delinquency rate stood at 1.07%. Although the commercial delinquency rate has risen, it’s also true that not all delinquencies result in foreclosure, especially in an environment where loan extensions and modifications are encouraged by regulators. In some cases, a lender will not negotiate unless the borrower is delinquent; in others, it’s just the process for negotiation.

Despite the wake of a pandemic economy and big changes in office use, there hasn’t been much bank system fallout.

There were five bank closures in 2023. While that seems like a lot, there were four bank failures in 2019 before the Covid-19 pandemic. The 2023 bank failures involved institutions with $548.7 million in total assets. Meanwhile, FDIC-insured institutions had a net income of $79.8 billion in the first quarter of 2023 — the highest on record — as well as $70.8 billion in the second quarter and $68.4 billion in the third quarter. The Deposit Insurance Fund (DIF) is funded mainly through quarterly assessments on insured banks. The FDIC itself has $119.3 billion in reserve.

Will Things Be Better In 2024?

It’s often suggested that nothing lasts forever, and when it comes to the economy we routinely swing from periods of economic growth to recession and back again.

“At KBS, we understand that there will be shifts in the market and uncertainties that arise,” said Robert Durand, KBS executive vice president of finance, “so we always take those risks into account in our investment strategies. Structuring our portfolios to weather these types of economic shifts helps them better perform over the long-term.”

While no one can promise what the future will bring, the worst of the pandemic-shaped economy may be behind us. For example, looking at the office market in general can hide strong markets and individual properties. As JLL noted in its third-quarter office outlook, “The outperformance of high-quality offices and new construction has been consistent since the pandemic outset, but substantial shifts in the development pipeline since the beginning of the interest rate hike cycle may drive intensification of flight to quality in the coming years.”

“Quality becomes everything, but the definition of quality is now more focused on the employee, not the employer,” said Aditya Sanghvi, a senior partner with McKinsey, speaking in October 2023. “That is a significant change in office real estate, because it’s about, can I get people to want to spend time in the office? That’s what employers care about as well. That’s what drives quality.”

The 10-year Treasury yield recently fell below 4.3% for the first time since September 2023, prompted by better-than-expected gross domestic product data and investors’ hopes that the Federal Reserve is finished with its rate-hiking campaign. The yield on the 10-year Treasury was about 7 basis points lower at 4.267%. That marks the first time since September that the benchmark rate trades below 4.3%.

U.S. Treasury Secretary Janet Yellen recently said she believes the U.S. economy does not need further drastic monetary policy tightening to stamp out inflationary expectations and was on track to achieve a “soft landing” with strong employment. Yellen said, “I believe the signs are very good that we will achieve this soft landing, with unemployment stabilizing more or less we’re where it is in this general vicinity and growth slowing to a sustainable level.”

A return to something closer to normal, whatever “normal” might be, would certainly be welcome after the ups and downs since 2019. The reality is that the office marketplace has changed significantly as a result of the pandemic. Just look at the growth of hybrid schedules, the flight-to-quality, the new competition for the best employees, AI growth, and steeper financing and refinancing costs.

Rather than a return to pre-pandemic conventions, we’re most likely at the start of a new normal, something not yet fully defined. For example, fewer people are voluntarily walking away from their jobs. There were 3.66 million “quits” in September, compared with 4.06 million a year earlier. Also, as Covid aid programs disappear, more of us are back on the job. There were 156.9 million people in the workforce in 2019 versus 160.6 million today.

Another change concerns the places where we work. In 2019, 5.7% of us worked from home. Home-based employees included 15.2% of the workforce in 2022 — that’s a big jump from 2019, but down from the 17.9% level we had in 2021, something not widely reported. The work-from-home movement is likely to contract even further in 2023 and 2024 as new corporate and government policies come into play.

Surprisingly, there are even suggestions that worries about downtown “urban doom loops” may be overblown. In San Francisco, for example, the city has taken an innovative approach to reactivating empty retail space in its Downtown, Embarcadero Center and surrounding streets.

Through its new Vacant to Vibrant program, San Francisco’s Office of Economic and Workforce Development makes grants to selected small businesses in an effort to provide entrepreneurs a rent-free platform to get their businesses in front of new customers while injecting arts, culture and a small-business feel into areas in desperate need. While cooperating building owners earn $5,000 to cover utilities and other costs, they also get the benefit of prospective tenants seeing a space’s potential.

“After struggling in the wake of the Covid pandemic,” said Bloomberg in October 2023, “downtowns across America are turning a corner. Even though workers have been slow to return and office vacancy remains high, residents have surged back and visitors and tourists have helped to fill much of the gap.”

Will 10-year Treasury Rates Fall?

Along with the fundamental changes now being seen in the office marketplace, there is also the possibility of lower financing costs. Ten-year Treasury rates — should they decline — would significantly impact the commercial real estate sector.

Wells Fargo, in a late-November commentary, said that its “base case forecast is for the FOMC to cut the fed funds target range by a cumulative 225 bps between Q1-2024 and Q1-2025. Easier monetary policy should help bring down 10-year Treasury yields, which we anticipate will end 2024 at 3.5%.”

CBRE, also in a November 2023 comment, noted that “The basic factors that drive global interest rates have not changed. There’s too much capital in the global economy chasing too few real investment opportunities. So, surplus capital will once again find its way into financial markets, boosting prices and reducing yields.”

The bottom line: Properties that don’t have workable numbers with today’s financing may become attractive if 10-year Treasury rates drop into the 3% or low 4% range. Borrowers with one- and two-year loan extensions may be able to refinance with better terms, especially if local vacancy levels improve. Lastly, if rates go down, owners and investors will want to take another look at the financing markets to see if they can lock in better options for the coming decade.

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