Investors Are Optimistic, but Real Estate Is Limping into 2025
Both the residential and commercial real estate investors are too optimistic about what lies ahead.
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In my column on Wednesday, I noted that I will be keeping a close eye on both the residential and commercial real estate sectors as this overbought market heads into the New Year.
There are many bubbles within the overall market which I have highlighted many times in the past few months. This week, investors have been treated to a dose of what happens when expectations get ahead of reality as the Dow is heading toward its worst weekly performance since March 2023.
The commercial and residential real sectors also seem to be pricing in a much rosier scenario than is likely to unfold in 2025. Home builder and housing-related stocks got a big initial boost when Chairman Powell finally started to cut rates in Mid-September after implementing one of the most aggressive monetary policies in the central bank’s history. However, while the Federal Reserve has cut the fed funds rate by 100 BPS with Wednesday’s 25 BPS reduction, the yield on the 10-year treasury has risen more than 90 basis points over that time. Evidently, the credit markets have more concerns around inflation and huge fiscal deficits than our monetary mavens do right now.
This has resulted in mortgage rates rising back up to the 7% level. Mortgage rates are likely to remain a huge headwind to the housing sector in 2025 after existing homes sales in 2023 and 2024 already were at their lowest levels since 1995. This means that home builders are going to have to continue to offer costly incentives like mortgage rate buy downs and free upgrades to move inventory. This obviously will not be good for profits or margins.
The CEO of Lennar LEN put these challenges succinctly when the huge home builder reported quarterly results on Thursday: "Initial signs of improvement in the housing market, driven by the Federal Reserve's interest-rate cuts, were overshadowed by affordability challenges as mortgage rates rose markedly."
Lennar’s stock sank by more than 5% in trading Thursday after results were posted and is a good harbinger of what is to come for the home building sector. A moribund housing sector also is hardly good news for housing-related stocks ranging from Home Depot HD, The Sherwin-Williams Company SHW and Ethan Allen Interiors Inc. ETH. That's one reason all of these stocks have given up their initial rallies following the first cut to the fed funds rate at the September FOMC meeting.
Then we have commercial real estate, which saw loan delinquency rates jump sharply in 2024 but has not found a bottom yet. The office market has been the most impacted with delinquency rates on CMBS against office property now north of 10%. While New York City does seem to be gaining considerable traction getting workers back in the office, other cities like Chicago, Los Angeles and San Francisco have not to this point. The overall office vacancy rate in the country remains at levels higher than the peak of the Great Financial Crisis.
In addition, delinquency rates on CMBS loans against retail and lodging properties are well north of 6% and the delinquency rate on multi-family properties came in at 4.18% in November, more than double where it stood just six months ago. I believe more pain is ahead for vast swaths of the CRE landscape in 2025 and "extend and pretend" will start to give way to lenders booking losses on their loan books in the coming year. Regional banks and other lenders to the CRE sector will see their losses increase in 2025 and this may impact credit availability to some parts of the economy, like small business going forward.
In summary, neither residential nor commercial real estate seems to be a good place as we close the books in 2024, and I will be watching both sectors closely as we enter 2025.
At the time of publication, Jensen had no positions in any securities mentioned.
