On September 18, 2024, for the first time in over four years, the Federal Reserve cut interest rates by 0.5%. Will this cut relieve the borrowing chokehold crippling the commercial real estate (CRE) industry? Opinions are mixed. Some say that it buys time for CRE holders, and that with the additional future cuts alluded to by the Fed, they will be able to hold out until refinancing becomes viable. Others claim that a rate cut will barely make a dent in the challenges that highly- leveraged CRE holders and investors are facing, and that banks will no longer wait patiently for them to address their debts.
According to CRE data firm Trepp, an estimated $2.2 trillion in commercial-property debt will be maturing between this year and 2027. CRE holders that invested using the artificially low, pre-pandemic interest rates are now seeking refinancing and find themselves in a very tight spot. The inevitable result is defaults and receiverships. Jeff Krasnoff, CEO of Rialto Capital, a real estate investment and asset management firm based in Florida, recently brought over fifteen foreclosure suits against borrowers from Signature Bank, which collapsed in 2023, alleging defaults exceeding $300 million. Other examples include investment firm Ashkenazy Acquisitions, multifamily syndicator GVA, and landlord Steve Croman, who account for approximately $751 million in defaults in 2024.
Until now, banks have been resorting to the “extend and pretend” game, where they’ve extended loan terms for struggling borrowers to help them avoid default, while waiting and hoping to see property values rebound. This unsustainable strategy is wearing thin, and, according to the Federal Reserve’s senior loan officer opinion survey released in May 2024, banks reported tightening their CRE lending policies during the first quarter of 2024. Banks are making efforts to reduce their exposure and have been quietly divesting troublesome portfolios of CRE loans in order to cut their losses – a reasonable move in light of 2023’s collapse of First Republic and Signature Bank, both of which were major commercial real estate lenders.
An analysis by S & P Global found that approximately 10% of the CRE mortgages maturing in 2024 are office properties. The post-pandemic shift toward remote and hybrid work arrangements have hit the office sector hard, generating vacancies and delinquencies. Trepp estimates that the U.S. office market has lost nearly a quarter of its value since the Federal Reserve began raising rates. Many of these office space owners are highly- leveraged or locked into floating rate debt and are struggling to stay viable. According to Shulem Rosenbaum CPA/ABV, Partner and business valuation expert at Roth&Co, the takeaway is that “overleveraging can be beneficial in stable markets, but carries significant risks in more turbulent times.”
What can we expect for the future? In a September 2024 press conference, Federal Reserve Chair Jerome Powell indicated that the Fed would consider additional cuts, by, “making decisions meeting by meeting, based on the incoming data, the evolving outlook, the balance of risks.”
Powell expects that the economy will continue its trend towards falling inflation and rising unemployment – a trend that prompted this first rate cut. The consensus among analysts and central bank officials is that more interest rate cuts will be forthcoming in 2024 and into 2025. A drop in the interest rate means that borrowing costs will ease and capital will free up. This will make financing new deals more attractive to investors and developers. More transaction activity will spur competition, and increased demand will bring up property prices. While many analysts believe most lenders and real estate owners can hold out until rates drop enough for refinancing, the support from the Fed won’t be sufficient for some of the country’s most heavily leveraged property investors.
Will rate cuts pull the CRE industry out of its pandemic-induced coma? U.S. economist and Nobel laureate Milton Friedman was no fan of central banking practices and its manipulation of interest rates. He believed, “cutting interest rates doesn’t create capital” nor increase real wealth, “it just shifts it around,” redistributing existing capital within the economy.
Rosenbaum asserts, “We have yet to see the positive effects of the Federal Reserve’s recent rate cuts on the CRE industry.” Initial rate increases occurred during a period when the CRE sector was already grappling with high vacancies and rent forbearances, while key COVID relief programs, such as the Paycheck Protection Program (PPP) were unavailable to many landlords. Other resources, like the Employee Retention Credit (ERC), were limited to businesses with small workforces. “While the Fed’s current actions may provide some temporary relief,” Rosenbaum contends, “we believe it is unlikely to deliver the comprehensive solution that the CRE industry urgently requires.”
This material has been prepared for informational purposes only, and is not intended to provide or be relied upon for legal or tax advice. If you have any specific legal or tax questions regarding this content or related issues, please consult with your professional legal or tax advisor.
