Will this give the market the psychological boost we’ve been waiting for?
While there is little doubt that commercial property values and borrowing costs are driven by macroeconomic trends and the balance between supply and demand, there is likewise no denying the impact of psychology when it comes to buying, selling and borrowing against commercial real estate.
We have observed through the years that real estate decisions are generally driven by a combination of empirical and emotional components. Put another way, a decision is not made until a person thinks his way into feeling good about that decision. Once the need for a change in situation is determined, then an objective evaluation of circumstances is pursued until the decision maker is sufficiently informed emotionally to commit to a course of action, even if that means doing nothing at all. The emotional “buy-in” is the catalyst to change and without it our natural desire for risk avoidance is equivalent to the proverbial broomstick in the spokes. But being emotionally committed supplies the energy and determination to move forward, especially when it comes to long-term commitments like the purchase of commercial real estate. The would-be buyer knows he’s making a big decision that he will likely have to live with for many years. Likewise, the property owner who sells knows there’s no turning back the clock after the closing. It’s that feeling that you’re doing the right thing that gets the deal across the finish line.
Integral to the psychological aspect of real estate decision making is the concept of getting a good bargain. Both buyer and seller must feel like what they are about to do is in their best interest and to their advantage. If both do, the deal gets done. If either of them doesn’t, no sale occurs. And, one of the key drivers in the owner/user decision matrix is mortgage interest rates, as controlling occupancy cost is a prime motivator for business owners to choose property ownership over the more flexible and less capital-intensive option of leasing.
For the decade ending in 2022, the cost of servicing real estate debt was at an historic low. Fully amortized SBA 504 loans fell to just 2.16% at one point, and that had a lot of owner/buyers feeling quite good about acquiring facilities for their own use. Prices literally quadrupled in 10 years, something no one in the commercial property business would ever have predicted. Supply dwindled as would-be sellers held onto properties that were appreciating at a double-digit annual pace. In fact, most owners during that time generated more wealth from property ownership than through the growth of their businesses.
Then came rampant inflation and the resulting spike in borrowing costs as the Fed was forced to raise the cost of capital to purge it. The party abruptly ended, buyers moved to the sidelines hoping to take advantage of a price correction that most of us thought was coming. Well, that didn’t happen. Would-be sellers joined buyers on the sidelines, content to occupy their highly appreciated assets with low-rate, long-term mortgages in place. Market sales activity ground to a halt, but prices were little changed because supply fell in sync with demand. Rates blew through the 4’s, 5’s and even 6’s, topping out in the low 7% range in October of 2023, all without a corresponding price decrease to offset the spike in borrowing cost. Suffice it to say, pretty much nobody felt good about buying a building and sellers were under little pressure to lower their prices to make deals happen. For you world history buffs out there, it was the equivalent of the Horse Latitudes in the North Atlantic.
Fast forward to today, and things are starting to look up. Mortgage rates have dropped substantially this year (down 59 basis points since January), there is more quality inventory for buyers to choose from, and pricing has softened, which has more potential sellers thinking realistically about their asking prices. The SBA 504 2nd mortgage rate has dropped to 5.9% and conventional lenders are pairing those 504 loans with 1st mortgages in the 5.5% range for qualified borrowers.
Are rates with a 5 as the first digit the psychological lift the market needs to get buyers feeling good about acquiring properties again? Preliminary indications tell us the answer is yes. We have seen an increase in active requirements from potential owner/users throughout the region and there is less of an expectation that rates will fall significantly lower, as the primary index for setting rates, the yield on the 10-year Treasury Note has stabilized at around 4%, which means mortgage rates should remain in the mid-to-high 5% range for the foreseeable future. Additionally, if the Fed keeps lowering its benchmark Fed Funds Rate through the end of the year, other borrowing costs are likely to decline, which should give the overall economy a needed boost.
Perhaps an even bigger motivator is the package of tax incentives that became law through the passing of the One Big Beautiful Bill Act (OBBBA) that retroactively offers 100% bonus depreciation and more generous Section 179 expensing limits. Click HERE for more on this topic. That paired with the cost segregation depreciation methodology has put more potential buyers back in play. We should start seeing the market impact of these new tax provisions early next year.
While there is still a fair amount of economic uncertainty out there, we believe the market is in the beginning stages of a psychological shift that will result in higher sale and lease activity going forward. And, with little inventory in the construction queue, the vacancy rate for both sale and lease product is likely to start heading back down again as transaction activity picks up. If that is the case and mortgage interest rates stay in the high 5’s, we could see another price spike in 2026. So, this is the time to get informed and be prepared to act. That’s where we come in. Just give us a call.