Important points
The Federal Reserve’s interest rate cutting cycle, which began earlier this month, is expected to ease some of the pressure on commercial real estate borrowers and their lenders. Post-pandemic work changes have put stress on office loans in particular, and experts believe the resilience of the U.S. banking system and the abundance of capital available to take over distressed assets will help limit the damage. says it will be helpful.
The Federal Reserve’s massive interest rate cut earlier this month sent ripples through financial markets, sending volatile assets like stocks and gold to record highs. However, the impact on the slow-moving commercial real estate market remains unclear.
Roughly $1 trillion in commercial real estate (CRE) debt comes due next year, nearly 8% of which is tied to the troubled office sector. Experts warn that interest rate cuts won’t save the office market from a painful reset, but they also think tattered commercial real estate is unlikely to weigh on the broader economy.
Will lower interest rates help commercial real estate?
Commercial real estate has been a concern for regulators and market participants since the Federal Reserve began raising interest rates in March 2022. CRE loans are often refinanced after five, seven, or 10 years, and a loan taken out in 2019 could be refinanced in late 2024. interest rate.
S&P Global estimates that the average interest rate for CRE bonds maturing in 2024 is 4.3%, while the average interest rate for bonds issued in 2024 is 6.2%. Investopedia estimates that if you refinance a $10 million, 30-year loan at these rates, your monthly payments will jump by nearly a quarter.
The Fed’s September rate cut and plans to continue lowering rates reduce the risk that holders of bonds maturing next year will not be able to refinance. Darin Mellott, vice president of capital markets research at real estate firm CBRE, said CRE loan rates, which are sensitive to the 10-year Treasury yield, have fallen from highs earlier this year, but there is still room for improvement. .
Mellott expects future interest rate cuts to push the 10-year Treasury yield down to the mid-3% range. “This is the range where the math starts to work out better, and many of these deals will be able to be refinanced,” he said.
The Fed’s move to cut interest rates sends a message to CRE investors that the expected “soft landing” for the economy is possible, Mellott said. “If the Fed sends that signal, market participants will have more confidence.”
Problems between offices and financiers
Office properties come with their own set of problems. Analysts at Deutsche Bank recently wrote about the troubled sector: “Office is undergoing an ‘obsolescence reset’ with worsening interest rates.”
The post-pandemic shift to working from home has changed the office landscape. The average lease size in the first half of this year was 27% lower than before the pandemic. Commercial real estate services firm Colliers estimates that nearly one-fifth of all office space in the United States was vacant at the end of the second quarter.
Rents and asset values for all but the most prestigious offices fell. CRE data firm Trepp estimates that the U.S. office market has lost nearly a quarter of its value since the Federal Reserve began raising interest rates. Empty offices can also reduce demand for nearby retail stores and other commercial buildings.
Some office owners are struggling to repay their loans. About 2% of all non-owner-occupied CRE loans were more than 90 days past due in the second quarter, the highest level since 2013, according to the Federal Deposit Insurance Corporation. Bank loan write-off rates were also the highest since 2013. 2013.
Banks are setting aside more funds to absorb losses. Allowances for credit losses totaled more than $23 billion in the second quarter, an increase of 13% from the previous quarter, according to the FDIC. A “deterioration” in the office market was cited as one of the reasons for the increase.
The situation is worse, but it wasn’t that long ago. In 2009, at the height of the subprime mortgage crisis, 8.7% of all CRE loans were delinquent, or 30 days past due, compared to 1.4% today.
Yet office owners and the banks that underwrote their loans across the country are facing billions of dollars in losses. Mellott estimates that banks’ CRE loan losses now amount to about $60 billion.
The pain has been eased by lenders’ willingness to extend existing loans, effectively deferring maturities and allowing borrowers to refinance later in a more favorable interest rate environment. Mellott said that would be preferable for banks to “recover the keys and realize the loss up front.”
But that doesn’t work for all real estate. “Loan extensions for buildings with 25% occupancy may not work,” said Aaron Giocka, director of national capital markets research at Colliers.
Market participants say some bank losses are inevitable. Analysts at S&P Global expect banks to write off more loans in 2025 than they did this year. Still, it’s unlikely to trigger a full-blown crisis that would spook banks. “This will probably be rolled out over a period of two to three years,” Mellott said.
Could CRE’s woes spill over into the broader economy?
While the current situation with banks saddled with bad real estate loans is similar to the crisis that sparked the Great Recession, most experts are optimistic about the risks the sector poses to the broader economy.
Data suggests that delinquencies are increasing fastest at the largest U.S. banks, and that banks are now finding themselves in the most difficult real estate: large banks in some of the nation’s most expensive markets. It had the scale to finance an office. However, these banks are also the ones that have the most stringent regulatory oversight and are held to the highest standards.
“Our financial system is in a much better position to meet the challenges of commercial real estate,” Giocka said.
Jodka also points out that while banks are likely to curb CRE lending to address immediate issues, there is still a lot of cash lying around to make up for that surplus. Data provider Preqin estimates that private equity firms have allocated more than $250 billion to invest in North American real estate.
Mr Giocca said the dry powder would likely help avoid the worst-case scenario of distressed properties being handed over to lenders and left vacant, hampering job creation and leaving local taxes short.
“That happens every time a building is built,” Giocca said of the vacancies. But commercial real estate’s eerie doom loop: “I don’t foresee it.”
