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Unseen upside: The commercial rebound nobody called

June 6, 2025 | 5 min read
Rich Hill
Global Head of Real Estate Research & Strategy
Art Jones
Senior Director, Global Real Estate Research and Strategy
Seema Shah
Chief Global Strategist
Christian Floro, CFA, CMT
Market Strategist

Changes in both commercial real estate (CRE) total returns and housing prices have historically moved in tandem. However, they have diverged from each other over the past couple of years, driven by the higher interest rate environment seen since the end of the pandemic, which, counterintuitively, has lifted housing prices while simultaneously weighing on CRE values.

Looking ahead, we expect the current divergence between residential housing and commercial real estate (CRE) to normalize over the near term. Home price appreciation is likely to slow amid an increasingly regionally bifurcated housing market, while CRE total returns are expected to continue accelerating—driven primarily by income, as capital returns remain muted. We believe investors should prepare to accept that the outperformance of CRE versus housing will hold for the foreseeable future and may even diverge again.

CRE and housing prices experience a rare divergence

Year-over-year (YoY) changes in unlevered commercial real estate (CRE) total returns and housing prices have diverged since Q1 2023. This is because quarterly total returns for CRE declined from 4Q22 to 3Q24, according to the National Council of Real Estate Investment Fiduciaries (NCREIF). At the same time, home prices rose over the same period, as measured through the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index. Most recently, however, the relationship has begun to flip, with year-over-year changes in CRE total returns recently changing from negative to positive in 4Q24 and continuing to accelerate in 1Q25, while housing prices have decelerated.

Divergences between CRE and housing have been rare in history, which—including this instance—have only occurred 20% of the time since the late 1980s. The divergences have largely been a byproduct of the lead-lag relationship heading into and throughout recoveries of economic downturns. In most instances, housing downturns are a leading indicator for CRE. Below are historical instances of this dynamic.

  • the seven quarters from 3Q10 to 1Q12 (when CRE rebounded first post GFC);
  • the seven quarters from 1Q07 to 3Q08 (when housing prices fell before CRE before the GFC);
  • the seven quarters from 1Q92 to 3Q92 (when CRE prices fell post S&L crisis while housing recovered), and;
  • the two quarters in 4Q90/1Q91 (when housing prices fell before CRE during the recession).

What makes today’s episode even more rare is that it has occurred despite an economic downturn. Indeed, this is the first time where CRE prices have turned negative, absent a recession and a corresponding decline in housing prices.

Disparate reaction to rising interest rates

The recent decline in CRE valuations, which saw unlevered prices decline by nearly 20% and levered prices fall by more than 30%, was driven by a combination of rising interest rates, tightening lending conditions, and decelerating net operating income growth. This came despite fundamentals remaining solid, with net operating income growth averaging +5% in 2023 across property types and +3.2% in 2024 versus the historical average of +2.5%.

By comparison, housing prices have risen to new record levels despite mortgage rates increasing at the fastest pace in at least 40 years to levels the market hasn’t seen since 2000, according to Morgan Stanley Research. However, many homeowners are locked into low mortgage rates, leaving them little incentive to sell their homes. The combination of higher home prices and higher interest rates has pushed home affordability to challenging levels, creating a very constrained supply environment, with listing volumes as a share of outstanding stock of single-family ownership at its lowest levels in in the data series' 40-year history.

The times they are a-changin’

Going forward, we anticipate an environment that supports CRE returns surpassing those of housing prices. In fact, interest rates drifting lower as economic activity slows may support CRE valuations. This could counterintuitively weigh on house prices as housing affordability improves, leading to a thaw in frozen supply. In other words, it’s an unwinding of the disconnected backdrop over the past couple of years, and it’s not unreasonable to expect the opposite to play out in the coming years.

There are early signs that this is already starting to occur as home prices have decelerated year-over-year to +3.4% in 1Q25 compared to a peak of +21% in 1Q22 and 6.6% as recently as 1Q24, driven by the emergence of a bifurcated market for home price appreciation.

While for-sale housing inventory remains very tight nationally, there are differences across the nation. Certain markets in Florida and Texas, for example, are seeing rising inventory compared to 4Q19 levels, while many markets in the Northeast and the Midwest are still down significantly.

This is leading to pronounced geographic differences in home prices. For instance, based on an analysis of 894 markets tracked by the Zillow Home Value Index (ZHVI), 30 out of the top 50 markets with the lowest home price appreciation in 1Q25 were in Florida or Texas. Meanwhile, 30 out of the top 50 markets with the highest home price appreciation were in Indiana, Kentucky, Ohio, and Wisconsin; only two markets were in the Sunbelt states.

By comparison, year-over-year changes in CRE total returns turned positive in 4Q24 and continued to accelerate higher in 1Q25 to +2.8%, given a combination of still solid fundamentals, improving lending conditions, and interest rates that have declined from peaks in late 2023. Our full-year 2025 projections for CRE are +5% as income returns are offsetting muted capital returns. This would mark the first time since 4Q22 that CRE returns are higher than housing prices. We expect annualized total returns to increase toward +7% over the next 5 years as capital returns turn positive coupled with solid income returns. We believe that seeing annualized 10-year returns of 8-9% that are in line with historical rolling average 10-year annualized returns is not unreasonable.

Investment implications

These disparate outcomes should remind investors to be increasingly aware of idiosyncratic forces that are driving valuations within single family and commercial real estate segments. Looking ahead, we expect year-over-year CRE total returns to outpace housing price growth, in line with their historical relationship—and potentially surpass the long-term average spread of +300 basis points—as CRE momentum builds and housing slows.

Ultimately, the traditional role of interest rates in real estate valuations has become less prevalent in the post-pandemic period, but interest rates are not the sole driver of CRE valuations. We believe income, which can vary by property type, will also be an important driver of CRE total returns over the next cycle. A cycle that is more likely to resemble the environment that persisted in the decades prior to the Global Financial Crisis versus the somewhat financially engineered returns post-GFC, that were driven by historically low interest rates.

Real estate
Macro views

Footnotes

Morgan Stanley Research. Global Securitized Products Mid-Year Outlook: Good Things Come to Those Who Wait.
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