S&P Global economists still expect a soft landing is the most likely outcome for the U.S. economy. Our base-case forecast for U.S. GDP growth remains 2.5% in 2024, slowing to 1.7% in 2025.

As the U.S. economy transitions to below-trend growth, we expect the unemployment rate to increase to 3.9% in 2024 and 4.2% in 2025. The weaker than expected July job reports and spike in unemployment raised the probability of a recession to 25%-30% in the next 12 months. We expect the broader improved inflation trend to continue and that the Federal Reserve will start cutting rates in September, a total of 125 basis points through the end of 2025.

Historically, interest rate cuts have been positive for real estate given the sector's capital intensity. The 10-year treasury yield is already trending below 4% as inflation cools and in anticipation of rate cuts, improving access to capital. Rate cuts could also escalate transactions and price discovery, in our opinion. We expect asset values to remain resilient or increase modestly as capitalization rates stabilize or move lower.

That said, the sector is not out of the woods just yet.   Fundamentals for commercial real estate (CRE) remain under pressure due to slowing economic growth and consumer spending. The sector is still adjusting to the sharp rise in rates and more limited access to capital for some borrowers. Rent growth has generally slowed and occupancy ticked lower, particularly in markets with higher supply such as multifamily housing in Sun Belt markets. Office fundamentals remain challenging with high vacancies and weak leasing trends, though the pace of decline seems to be decelerating and reaching an inflection point. Loan delinquencies continue to increase for lower-quality office assets as values are reset amid a slow utilization recovery. We expect lenders will work through a significant amount of troubled loans and distressed assets over the next year.

Despite high mortgage rates, homebuilders have performed better than expected due to resilient demand amid short supply. Given record housing prices and worsening housing affordability, rental housing REITs remain resilient despite a deceleration, with rent growth and a limited drop in occupancy. In many markets, the rent-to-own equation still favors rentals given record home prices and high mortgage rates.

Equity REITs

Rated entities reported resilient operating performance across most property types in the second quarter.   Positive rating actions outpaced negative actions in recent months, primarily in the retail and net lease sectors. We upgraded Phillips Edison & Co. Inc. and Kite Realty Group L.P. to 'BBB' from 'BBB-' based on our expectations that both will continue to report healthy operating performance with positive net operating income growth and sustained lower leverage. We also upgraded Agree Realty Corp. to 'BBB+' from 'BBB' given its demonstrated commitment to disciplined growth, with debt to EBITDA in the 6x area and a sector-leading, investment-grade rated tenant base.

Still, we maintain a negative rating bias for the sector; about 25% of ratings have negative outlooks (Charts 1 and 2). Office REITs represent the bulk of that bias given that secular headwinds, cash flow pressure, and higher financing costs continue. We have negative outlooks on about 80% of office REITs. While they reported operating results that held up relatively well in the second quarter, with some recovery in leasing and relatively stable occupancy, high concessions and low retention rates continue to pressure cash flow.

We expect the bifurcation of class A to class B to persist, with REITs that hold high quality assets outperforming the broader office market and maintaining higher occupancy in the mid- to high-80% range.

We expect transactions to pick up over the balance of the year as the impact of lower interest rates drives a more pronounced recovery in transactions.   Activity has ticked up with Blackstone's acquisition of Apartment Income REIT Corp. (AIR). We withdrew our ratings on AIR following close of this transaction. We expect well capitalized REITs with balance sheet capacity to pursue a more normal level of acquisitions following a period of muted activity. For example, Equity Residential purchased a portfolio of 11 apartment properties in the Atlanta, Dallas, and Denver markets from Blackstone for $964 million to increase its presence in those areas.

Access to capital has improved for most REITs, driving higher debt and equity issuance in recent months. Debt issuance spiked in July and August as the 10-year yield narrowed significantly below 4%, but overall debt issuance remains slightly below last year at $29 billion as of July 2024 versus $32.7 billion a year ago. REITs also issued more equity given improving share prices. The discount to net asset value has narrowed in the REIT sector to 8.4% on average from 15.5% in June. Office REITs still trade at a wider discount of 16.4% while shopping centers trade at a narrower discount of 5.9%.

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CRE Fincos

Difficult conditions in this market caused operating performance for rated commercial mortgage REITs to decline for the first half.  In the second quarter, CRE finance companies continued to build loan loss reserves related to underperforming loans, realized losses as they transitioned some of their watch list loans to real estate owned (REO), and downgraded their own internal risk ratings on many loans to the higher-risk '4' and '5' categories. At some CRE lenders we rate, the value of these loans is over 100% of adjusted total equity (our measure of capital), which we view as elevated. Recently, we revised our outlook on Blackstone Mortgage Trust Inc. (BXMT) to negative from stable with a 'B+' rating due to weaker asset quality and rising leverage.

Over the past 12 months, many CRE lenders' distributable earnings have plunged, prompting some to cut dividends to protect liquidity. For instance, beginning in the third quarter of 2024, BXMT lowered its quarterly dividend per share about 24% to 47 cents from 62 cents, and Claros Mortgage Trust Inc. lowered its dividend about 60% to 10 cents from 25 cents per share. This year, KKR Real Estate Finance Trust Inc. lowered its quarterly dividend about 42% to 25 cents from 43 cents per share. While this improves liquidity and earnings retention, we expect it to be somewhat offset by climbing liquidity needs as asset credit quality remains pressured and the REO portfolio builds. Over the next year, CRE finance companies will, in our view, remain selective with originations and focus on preserving liquidity.

The companies we rate depend on secured financing in repurchase facilities that often have an interest-coverage covenant requirement. During the second quarter, higher interest rates reduced the cushions to interest coverage covenant requirements. Companies prudently worked with lenders to amend the threshold by reducing it.

S&P Global economists expect the rising possibility that policymakers could use easing inflation and slowing growth momentum to adopt more dovish language and signal a rate cut in September. As base rates decline, we could see an uptick in CRE transactions as capitalization rates stabilize or move lower. However, the fundamentals remain under pressure. We think it's likely that CRE finance companies' loan portfolios could remain stressed, particularly those with high office exposures.

We've also seen some strain in the multifamily sector due to increased supply, slowing rent growth, and high interest rates. A rise in troubled multifamily loans could hit asset quality since most CRE lenders have increased their exposure to multifamily since 2020 to offset office exposure. The combined exposure to office and multifamily made up 55%-70% of the portfolio as of June 30, 2024 (Chart 4).

Given the ongoing stress in CRE, downward rating pressure remains. We could take further negative rating actions if asset quality continues to deteriorate, leverage approaches our downside thresholds, covenant cushions to funding lines erode, or liquidity becomes strained (Chart 3).

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CRE Services

Recurring property and facilities management businesses continue to perform well, while CRE sales and leasing transactions may be at an inflection point.   The rapid rise in interest rates has led to an industrywide decline in CRE capital markets and leasing since the second half of 2022. While CRE investor sentiment remains mixed and further price discovery is needed, prices have adjusted significantly from peaks. Interest rate stability and expectations around cuts could encourage occupiers and investors to deploy capital accumulated over the past two years. Office leasing has gradually improved in 2024, driven by increased deal size and transaction volumes from improved business confidence. However, industrial leasing continues to normalize from elevated levels during the height of the COVID-19 pandemic.

We expect CRE services companies with large property and facilities management businesses to continue to perform well, benefiting from recurring revenue and multiyear contracts with high switching costs. We also expect robust growth driven by new and existing client expansion, particularly in the industrial and logistics sectors. For the remainder of the year, we expect companies to prioritize organic growth and remain disciplined in shareholder-friendly initiatives. For those with excess capital, we believe mergers and acquisitions will likely be in areas that can generate resilient revenues and broaden existing service offerings.

While we expect a better operating environment over the next 12 months, we maintain negative outlooks on Jones Lang LaSalle Inc., Cushman & Wakefield, and Avison Young (Canada) Inc.

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Homebuilders

Operating performance for homebuilders remains in line with our expectations.   We still expect higher revenues through more communities and closings on average and profit margins to narrow in 2025 relative to 2024. Despite mortgage rates still hovering near 7%, homebuyers have acclimated and maintained steady buying habits. Low supply of homes, a healthy labor market, and resilient economic outlook still support demand through 2025 despite continued affordability challenges. As the resale supply recovers, we expect continued discounts and incentives to spur what has become an industry focused on deliveries and returns following investments in land growth and continued operations.

We expect conditions for homebuilders will continue to normalize. John Burns Research and Consulting estimates that public builders contribute 47% of all U.S. new home sales. We believe this will decline with anticipated interest rate cuts, which should renew the supply of resale homes in the market. Public builders will continue to rely on greater access to capital and incentives to compete against a resale market. We believe margins will be pressured over the coming quarters, and in most cases forecast a year-over-year decline in EBITDA margins in 2025 from 2024. However, compressed margins in 2025 would still be higher than historical averages for most of the industry.

We expect rating stability for the remainder of 2024.   This follows several upgrades and revisions to positive outlooks in 2023 and 2024 and given that 93% of our ratings have stable outlooks (Chart 5). Although we are gaining better visibility to 2025, there isn't yet a need for any further positive rating actions for homebuilders aw we took positive rating actions on most companies in the last 12-18 months (Chart 6). Our outlooks typically speak to time horizons of 12 months for speculative-grade issuers and 24 months for investment-grade credits.

We recently revised our outlook on PulteGroup Inc. (BBB) to positive from stable. Since 2021, the company has repaid debt and increased adjusted EBITDA, keeping its balance sheet above $1 billion. We believe the company is better capitalized than in past cycles, which ensures it is positioned to withstand softer macroeconomic or industry conditions than expected. Additionally, we revised our outlook on The New Home Co. Inc. (B-) to positive due to its forecast improving leverage along with its entry into new markets, adding diversity from its primary markets in California. We also upgraded Weekley Homes LLC (BB/Stable/--) because we forecast its leverage and operations will be commensurate with a 'BB' rating at 1.3x-1.5x debt to EBITDA for the next 12 months.

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Building Materials

The sector continues to face weak demand mainly because of lower repair and remodeling spending, delayed projects, and high interest rates.   This along with weak multifamily residential construction has not fully been offset by more stable single-family residential construction. Weaker revenues and earnings have hit distributors because of lower lumber prices and soft demand in certain commercial sectors such as office. However, price stability and some commodity deflations have helped mitigate some of the impact, including preserving profitability.

We expect continued modest pressure through the remainder of 2024 with the potential for improvement in 2025. The first of several Fed rate cuts could come as early as September, which could increase home renovation and other spending. However, the pace and speed of the improvement is unclear.

We recently revised the outlook on Griffon Corp. to positive from stable, mainly because of low leverage for the rating. The company has maintained a higher-margin profile, which has supported improved credit metrics. The better margin profile is due to strategic initiatives related to portfolio optimization, global sourcing, operating efficiencies, and cost controls. We revised our outlook on Arcosa Inc. to negative from stable following the announcement of a large debt-financed acquisition. Its S&P Global Ratings-adjusted debt increased three times leverage at year-end 2023, with debt reaching $1.9 billion. The negative outlook indicates minimal cushion against downside risks including earnings softness or the failure to reduce debt as expected.

The rating outlook for the building materials sector is largely stable, with 81% of ratings with stable outlooks, 11% with positive outlooks or on CreditWatch with positive implications (Charts 7 and 8). Only 8% of outlooks are negative as of Sept. 5, 2024.

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