How will the US banking system address this CRE crisis in the making, coming to theatres soon? The Fed’s Rate Cuts Won’t Save Commercial Real Estate
By
Greg Friedman
Sept 20, 2024, 1:18 pm EDT
About the author: Greg Friedman is CEO of Peachtree Group, a real estate investment firm.
The need for the commercial real estate industry to recalibrate is becoming urgent. A record $1.5 trillion in commercial real estate loans are set to mature over the next 18 months. These loans, many secured under highly favorable terms, will need to be refinanced or serviced at much higher rates, putting borrowers under significant strain while access to capital tightens.
The Federal Reserve’s first rate cut in four years sets off a new phase in the economic cycle. We expect the federal funds rate to stabilize, eventually landing in the low to mid-3% range. While this marks a significant drop from current levels, it’s important to recognize that this range still represents an eye-popping 300% increase compared to the average rate in the decade leading up to 2019.
This dramatic shift in borrowing costs signals a new “normal” and will directly impact industries like commercial real estate that have prospered in the low-interest-rate environment. As borrowing costs rise and valuations come under pressure, cap rates will increase as the market adjusts to this higher cost of capital.
Today’s environment—shaped by monetary policy—presents challenges unlike anything seen before.
Historically, the Fed has responded to economic crises by swiftly cutting interest rates following financial disruptions. This time, however, we expect a more measured approach. Rather than reacting to a sudden breakdown, the Fed seems poised to lower rates gradually, aiming for a “soft landing” scenario where inflation remains under control, leading to a more gradual stabilization of the economy.
The low interest rates and extensive government stimulus of 2020 and 2021 provided an artificial boost to the commercial real estate sector, enabling it to perform better. However, these short-term relief measures have faded as rates remain elevated.
While it’s tempting to look to history for guidance, the economic landscape of the past four years is truly unprecedented. The confluence of a global pandemic, extraordinary fiscal stimulus and historically low interest rates has created conditions unlike anything we’ve seen.
Navigating today’s commercial real estate landscape demands more than just a grasp of market dynamics; it requires foresight, adaptability, and a keen eye for emerging opportunities. While the hope for a soft economic landing may prevent the worst-case scenario of a deep recession, it won’t shield the commercial real estate industry from the pressures of rising borrowing costs and the wave of maturing debt. Yet, there are always ways to find an advantage in disruption.
As interest rates remain elevated, many properties—particularly those burdened by maturing low-rate loans—may find themselves in financial distress. This situation creates an opportunity, with a forced sale or debt restructuring, potentially allowing the acquisition of a property at a reset basis. In doing so, new ownership groups can realign the capital structure to fit current economic conditions better, resetting the property’s financial trajectory.
In this environment, capital-stack repositioning becomes a powerful tool. Investors can step in with fresh capital to restructure existing deals by layering in mezzanine debt, bridge loans, or even using preferred equity. These approaches provide flexibility and offer liquidity for struggling projects to avoid default and can breathe new life into otherwise stalled projects.
Private credit is another critical lever, particularly as traditional lenders pull back due to heightened risk or tightened underwriting standards. Where equity investment is sluggish, private credit becomes a vital source of liquidity.
Opportunistic buying is yet another avenue to explore, especially in offices or retail, which face significant distress. These distressed assets can be acquired at discounted prices with the right vision. Strategic repositioning—such as converting an underperforming office building into residential units—can unlock value and turn a struggling property into a profitable venture.
Collaboration with lenders and property owners is also crucial. Stressed borrowers may be looking for ways to restructure their debt, and lenders, eager to avoid default, may be open to renegotiation. This creates an opening for investors to acquire distressed loans or forge joint ventures, stepping in as financial partners to stabilize the property in exchange for a restructured deal.
By leveraging these strategies, commercial real estate investors can not only weather the current market dislocation but also emerge stronger, armed with creative financing solutions and fresh capital. In the end, those who can navigate the challenges of today’s environment will be well-positioned to benefit from the eventual market stabilization and growth that inevitably follows.
