Will the Fed’s Rate Cuts Save Commercial Real Estate?

Key Takeaways

• The Federal Reserve’s rate-cutting cycle, begun earlier this month, is expected to alleviate some of the pressure on commercial real estate borrowers and their lenders.
• The post-pandemic shift in work habits has put particular stress on office loans, which are expected to burden U.S. banks with tens of billions of dollars in losses in the coming years.
• Experts say the resilience of the U.S. banking system and an abundance of capital available to take over distressed assets should help contain the damage.

The Federal Reserve’s jumbo interest rate cut earlier this month has quickly rippled through financial markets, lifting nimble assets like stocks and gold to record highs. Its impact on the slow-moving commercial real estate market, however, remains unclear.

Approximately $1 trillion of commercial real estate (CRE) debt is coming due next year, nearly 8% of which is tied to the troubled office sector. While experts warn that rate cuts won’t save the office market from a painful reset, they also believe battered commercial real estate isn’t likely to tank the broader economy.

Will Rate Cuts Help Commercial Real Estate?

Commercial real estate has concerned regulators and market participants ever since the Federal Reserve began raising interest rates in March 2022. CRE loans are often refinanced after 5, 7, or 10 years, meaning loans taken out in 2019 may be set to refinance at higher 2024 interest rates. 

S&P Global estimates that the average rate on CRE debt maturing in 2024 is 4.3%, while debt originated in 2024 has an average rate of 6.2%. The monthly payment on a $10 million, 30-year loan refinanced at those rates would jump by nearly a quarter, according to Investopedia estimates.

The Fed’s September rate cut—and its plan to continue cutting rates—lowers the risk that the holders of the debt maturing next year won’t be able to afford refinancing. While CRE loan rates, which are sensitive to the 10-year Treasury yield, have declined from their highs earlier this year, there’s still room for improvement, says Darin Mellott, VP of Capital Markets Research at real estate firm CBRE.

Mellott expects future rate cuts to nudge the 10-year yield down to the mid-three percent range. “That’s a range where the math starts to work out a lot better, and a lot of these deals are going to be able to get refinanced,” he said.

The Fed’s pivot to rate cuts also sends a message to CRE investors that the hoped-for economic “soft landing” is possible, Mellott said. “When the Fed signals that, market participants are going to have a lot more conviction.”

The Problem With Offices—and Lenders

Office properties have their own issues. “Office is undergoing ‘obsolescence reset” that interest rates have exacerbated, Deutsche Bank analysts wrote recently of the troubled sector. 

The post-pandemic shift to work-from-home has altered the office landscape. The average lease size in the first half of this year was 27% smaller than before the pandemic. Commercial real estate services firm Colliers estimates that nearly a fifth of all U.S. office space was vacant at the end of the second quarter.

Rents and property values of all but the highest-end offices have slumped. 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 rates. And empty offices can mean less demand for nearby retail and other commercial buildings.

Some office owners are struggling to pay back their loans. Nearly 2% of all non-owner occupied CRE loans were overdue by 90 days or more in the second quarter, the highest level since 2013, according to the Federal Deposit Insurance Corp. The rate at which banks wrote off loans was also the highest since 2013.

Banks are increasing the money they set aside to absorb losses. Credit loss provisions totaled more than $23 billion in the second quarter, according to the FDIC, up 13% from a quarter earlier. The “deterioration” of office markets was one of the reasons cited for the increase.

The situation has been worse—and not that long ago. In 2009, at the height of the subprime mortgage crisis, 8.7% of all CRE loans were delinquent, or 30 days overdue, compared with 1.4% today.

Nonetheless, across the country, office owners and the banks that have underwritten their loans are sitting on billions of dollars of losses. Mellott estimates banks’ CRE loan losses currently total about $60 billion. 

The pain has been mitigated by a willingness on the part of lenders to extend existing loans, effectively pushing out maturities and allowing borrowers to refinance later in a more favorable rate environment. Banks, Mellott said, would prefer that than ” taking the keys back and realizing the loss up front.”

But that may not work for all properties: “Extending a loan on a 25% occupied building may not work out,” says Aaron Jodka, Director of National Capital Markets Research at Colliers.

Some bank losses are inevitable, market watchers say. S&P Global analysts see banks writing off more loans in 2025 than they have this year. Still, they’re unlikely to trigger a full-blown crisis that takes banks by surprise. “You’ll see this probably play out over a period of two to three years,” says Mellott.

Could CRE Distress Spill Over to the Broader Economy?

While the present situation—banks sitting on bad real estate loans—bears passing resemblance to the crisis that sparked the Great Recession, most experts are sanguine about the risk the sector poses to the broader economy. 

Data suggests delinquencies are rising fastest at America’s largest banks, which had the size to lend against the properties that are now the most distressed: large offices in some of America’s most expensive markets. Those banks, however, are also the ones subject to the most stringent regulatory oversight and held to the highest standards.

“Our financial system is far better positioned to handle a challenge in commercial real estate,” Jodka said.

And while banks will likely rein in their CRE lending as they work through their present issues, Jodka notes there’s plenty of money sitting on the sidelines to pick up the slack. Data provider Preqin estimates private equity firms have allocated more than $250 billion to invest in North American real estate.

That dry powder, says Jodka, is likely to help avert a worst-case scenario in which distressed properties are turned over to lenders and lay vacant, stunting job creation and starving municipal tax rolls. 

“Building by building, that can happen,” says Jodka of vacancies. But the ominous commercial real estate doom loop: “I do not foresee that.”

Read the original article on Investopedia.