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The Federal Reserve's massive interest rate decrease earlier this month has quickly rippled across financial markets, propelling nimble assets such as equities and gold to all-time highs. Its influence on the sluggish commercial real estate market, however, is unknown.
The recent rate cut has sparked intense debate among economists and market analysts. Some argue that the move was necessary to stimulate economic growth and prevent a potential recession, while others express concern about the long-term implications of prolonged low interest rates. The impact on various sectors of the economy, including commercial real estate, remains a topic of keen interest and speculation.
Approximately $1 trillion in commercial real estate (CRE) debt is due next year, with approximately 8% attributed to the ailing office sector. While analysts caution that rate cuts will not save the office market from a harsh reset, they also believe that battered commercial real estate is unlikely to derail the overall economy.
Will rate cuts benefit commercial real estate?
Since the Federal Reserve began rising interest rates in March 2022, commercial real estate has been a source of anxiety among regulators and market participants. CRE loans are frequently refinanced after 5, 7, or 10 years, therefore loans made in 2019 may be refinanced at higher 2024 interest rates.
S&P Global anticipates that the average rate on CRE debt expiring in 2024 is 4.3%, while the average rate on debt created in 2024 is 6.2%. Refinancing a $10 million, 30-year loan at such rates would result in a nearly 25% increase in monthly payments.
The Fed's September rate decrease, and its commitment to continue decreasing rates, reduces the danger that holders of debt maturing next year may be unable to refinance. While CRE loan rates, which are sensitive to the 10-year Treasury yield, have fallen from their peak earlier this year, Darin Mellott, VP of Capital Markets Research at real estate firm CBRE, believes there is still room for improvement.
Mellott expects future rate decreases to reduce the 10-year yield to the mid-three percent area. "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 told me.
The Fed's shift to rate decreases also signals to CRE investors that the desired economic "soft landing" is attainable, according to Mellott. "When the Fed signals that, market participants are going to have a lot more conviction."
This shift in monetary policy has broader implications for the real estate market as a whole. Residential real estate, which has been grappling with affordability issues due to high mortgage rates, may also see a boost. Lower interest rates could potentially reignite demand in the housing market, leading to increased construction activity and potentially easing some of the supply constraints that have driven up home prices in recent years.
The Problem With Offices—and Lenders
Office buildings have their own difficulties. "Office is undergoing 'obsolescence reset" that interest rates have aggravated, Deutsche Bank analysts said recently about the struggling industry.
The post-pandemic move to work-from-home has transformed the office scene. The average lease size in the first half of this year was 27% smaller than prior to the epidemic. Colliers, a commercial real estate services firm, estimates that approximately a fifth of all office space in the United States was unoccupied at the end of Q2.
Rents and property prices for all but the most expensive offices have fallen. Trepp, a commercial real estate statistics firm, believes that the US office market has lost about a quarter of its value since the Federal Reserve began raising interest rates. Empty offices might also result in decreased demand for surrounding retail and commercial buildings.
Some office owners are struggling to repay their loans. According to the Federal Deposit Insurance Corporation, about 2% of all non-owner-occupied CRE loans were 90 days or more past due in the second quarter, the highest percentage since 2013. The rate at which banks wrote down loans reached its highest level since 2013.
Banks are boosting the amount they set aside to cover losses. The FDIC said that credit loss provisions totaled more over $23 billion in the second quarter, a 13% increase from the previous quarter. The "deterioration" of office markets was one of the explanations given for the increase.
The situation has been worse before—and not long ago. In 2009, during the peak of the subprime mortgage crisis, 8.7% of all CRE loans were delinquent, or 30 days past due, compared to 1.4% currently.
Nonetheless, across the country, office owners and the banks that underwrote their loans are sitting on billions of dollars in losses. Mellott thinks that banks' CRE loan losses currently amount approximately $60 billion.
The pain has been alleviated by lenders' readiness to extend current loans, effectively delaying maturities and allowing borrowers to refinance later in a more favorable rate environment. Banks, Mellott added, would prefer that to "taking the keys back and realizing the loss upfront."
However, this may not be applicable to 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 unavoidable, according to market analysts. S&P Global analysts expect banks to write down more debts in 2025 than they have this year. Nonetheless, they are unlikely to spark a full-fledged crisis that catches banks by surprise. "You'll see this probably play out over a period of two to three years," according to Mellott.
The challenges facing the office sector have led to innovative solutions and adaptations within the industry. Many property owners are exploring ways to repurpose underutilized office spaces. Some are converting offices into residential units, addressing housing shortages in urban areas. Others are reimagining office designs to accommodate hybrid work models, incorporating more collaborative spaces and advanced technologies to attract tenants. These adaptations could potentially reshape urban landscapes and work environments in the coming years.
Could CRE distress spill out into the broader economy?
While the current situation—banks waiting on poor real estate loans—has a passing resemblance to the catastrophe that triggered the Great Recession, most experts remain optimistic about the sector's risk to the overall economy.
According to data, delinquencies are rising quickest among America's largest banks, which had the size to lend against the most troubled properties: enormous offices in some of America's most costly locations. However, these institutions are also subject to the most intense regulatory monitoring and must adhere to the highest standards.
"Our financial system is far better positioned to handle a challenge in commercial real estate," Jodka told reporters.
And, while banks are likely to reduce their CRE lending as they work through their current challenges, Jodka argues that there is plenty of money on the sidelines to fill the gap. Preqin estimates that private equity firms have invested more than $250 billion in North American real estate.
According to Jodka, this dry powder will likely help avert a worst-case situation in which troubled homes are turned over to lenders and remain vacant, stifling job development and depleting local revenue rolls.
"Building by building, that can happen," Jodka said of vacancies. However, the scary commercial real estate doom loop: "I do not foresee that."
The evolving landscape of commercial real estate is also influencing urban planning and development strategies. City planners and policymakers are reassessing zoning laws and infrastructure needs in light of changing work patterns and property usage. Some cities are exploring ways to revitalize downtown areas that have been impacted by reduced office occupancy, focusing on creating mixed-use developments that combine residential, commercial, and recreational spaces. These efforts could lead to more resilient and diverse urban environments, potentially mitigating some of the negative impacts of the current CRE challenges.
