What If the Fed Doesn’t Cut Interest Rates in 2024?

Commercial real estate — its lenders in particular — brace for a years-long fallout

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The commercial real estate industry entered 2024 with plenty of optimism after the Federal Reserve Board signaled during its December meeting that lower interest rates were around the corner. After all, transaction volume had slowed to a crawl the previous 18 months, and lower rates would spur dealmaking activity and lower financing costs dramatically. 

The Fed’s post-meeting statement on Dec. 13 projected three interest rate cuts in 2024, up from one anticipated after the previous meeting in early November. Meanwhile, many on Wall Street had excitedly priced in as many as six cuts for the year ahead. Six weeks later, though, Fed Chairman Jerome Powell gave the capital markets a reality check when he said the timing of any future cuts would hinge on the central bank “gaining confidence that inflation is on a sustainable path down to 2 percent.”

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Two weeks after the Fed’s Jan. 31 meeting, the prospects of rate cuts took a further hit when it was announced that the Consumer Price Index for January was up 3.1 percent year-over-year, higher than the 2.9 percent forecasted by economists. The inflation gauge had peaked at 9.1 percent in summer 2022 just as the Fed began to bring rates up from near-zero borrowing levels to a benchmark interest rate between 5.25 percent and 5.5 percent.

Further, as recently as Feb. 29, the Personal Consumption Expenditures Price Index, released by the Bureau of Economic Analysis, showed prices for goods and services rose 0.4 percent monthly in January, in line with Wall Street’s expectations and another body blow to possible rate cuts. 

So … what if the cuts don’t happen?

Or, more likely, what if the cuts are not nearly as deep as had been believed back in December? 

“I think the one key impact of higher for longer rates or higherish for longerish rates is clearly going to be that fewer existing loans will be refinanceable at their current loan proceeds,” said Charlie Rose, managing director at Invesco Real Estate (IVZ). “In a higherish for longerish scenario, I would expect that we would see more assets need to sell rather than be refinanced, and increasing the need for gap financing to refinance some of those assets whether it is in the forms of mezzanine or preferred equity.”

While uncertainty lingers about when the Fed might cut rates, Rose said the Fed signaling that rates have peaked marks an important first step toward setting in motion a recovery in the CRE markets. He said consensus on the central bank’s long-term federal funds rate is needed, though, to help narrow bid-ask spreads between buyers and sellers to spur more transactions that ignite the CRE debt markets again at scale.

The Fed enacted hikes in 11 of 12 meetings from March 2022 to July 2023, which moved interest rates to their highest level in 22 years. The last Fed interest rate cut came in mid-March 2020 at the onset of the COVID-19 pandemic. 

Rose said that Invesco has seen increased demand from borrowers of late given that 26 percent of lenders have exited the CRE lending market over the last year, with bank lending down a full 73 percent over the year. He stressed that as interest rates remain elevated, it will make it that much more important for Invesco to continue its strategy of working with banks to buy loans in a partnership role with a risk-sharing structure. Rose noted that many institutions had record-low loan-to-value ratios and record-high debt service coverage ratios in late 2022. 

“They are seeing debt service coverage ratios tighten in those loan books. And, accordingly, even on loans that still have healthy loan-to-value ratios and are still fully performing with strong and relationship borrowers, they may have increased capital charges against those loans,” Rose said. “We’ve been working with some of those counterparties to help solve some of their balance sheet optimization issues through partnering with them on high-
quality loan portfolios to either buy subordinate tranches or purchase loan pools outright.” 

CBRE Investment Management is projecting that interest rate cuts will begin in June and likely only amount to around a 75 basis point reduction at most for 2024, far lower than what the market had hoped for in late 2023. Richard Barkham, global chief economist at CBRE, said during a Feb. 29 lunch briefing that higher for longer interest rates will contribute to a loss or absorption of 300 to 400 banks over the next five years due to CRE lending losses. 

Barkham said that while he expects there to be some modest Fed interest rate cuts in the middle of 2024, he noted that if the central bank does not take this path it will cast further headwinds against an already strained CRE market.

“It will send values down a bit further than we suggested, and it will prevent the revival of investor activity into the real estate market until 2025,” Barkham said. “There will be more capital required to go into the sector.”

Larry Grantham, managing principal at Los Angeles-based bridge lender Calmwater Capital, said expectations of fewer rate decreases in 2024 than initially envisioned have placed “tremendous pressure” on CRE owners due to higher borrowing costs eating into their liquidity. He said the CRE market is looking at material distress if rates stay higher for longer and even if the Fed does implement some cuts in 2024.

“It’s not about whether there’s two rate decreases or three this year. It is about what is the slope of the rate decline over the next two years,” Grantham said. “If there is not a meaningful decline, there will be more distress.”

While much of the CRE distressed loans have been in the office sector, multifamily assets also risk default should interest rates remain near current levels because many of these properties were purchased with floating-rate debt, Grantham said. He stressed that gap financing will become more crucial if rates don’t come down and borrowers with looming maturing loans are unable to contribute the necessary equity for a refinance. 

Calmwater Capital said it is positioned better than other lenders amid the choppy markets after retooling its lending portfolio to 80 percent in industrial and multifamily assets compared with the 60 percent it had concentrated in office, hospitality and retail before the pandemic. 

Grantham, who noted that Calmwater now has exposure to only one office property in its two funds, said the growing importance of private lenders will be magnified the longer interest rates remain elevated.

“Five years ago, private debt wasn’t an institutionally recognized global asset class. Today it is and is gaining market share, and it’s going to continue as banks remain on the sidelines,” Grantham said. “Some private debt lenders, like any managers, are better fiduciaries and more prudent than others, but our expectation is the asset class will make it to the other side stronger.”

David Nasatir, chair of law firm Obermayer Rebmann Maxwell & Hippel, said many deals are on the sidelines now because of the “hope” that rates will go down, but he sees no indication of that reality playing out based on inflationary trends. Instead, borrower clients with loans coming due early this year are seeking to extend for another six months to a year, with some also trying to assure lenders by either putting in more equity or increasing reserves.

If interest rates are not reduced this year, Nasatir said it will accelerate a trend that has unfolded over the past year where sponsors add collateral from other projects as mortgage debt in exchange for an extension on a distressed property. Lenders in general are receptive to finding creative ways to avoid having to take back the keys on assets and avoid a distressed sale scenario, he said.

“I think there’s a very strong tendency among lenders to try and negotiate an extension to find a compromise that works for them and their borrower because they do not want to take the property back,” Nasatir said. “Banks are not in the real estate brokering business, so they’d much prefer to keep assets going and keep them attractive to a potential buyer that might also cause the loan to get paid off.”

The higher interest rate climate has led some lenders to explore including Commercial Property Assessed Clean Energy (C-PACE) loans in the capital stack as an avenue for borrowers to refill interest reserves and buy time to enable property stabilization and avoid having to take back assets.

Mansoor Ghori, CEO and co-founder of Petros PACE Finance, said the longer the Fed takes to materially bring down rates, the more demand there will be for C-PACE loans. While this dynamic would be good for his lending sector, Ghori said there would also be “chaos” for the roughly $1 trillion in CRE loans maturing over the next two years with much of the debt unable to get refinanced. Short-term pain from banks selling nonperforming loans off their balance sheets is what is needed for long-term gain in the CRE market, Ghori said.

“That flushing [through] is what’s needed in the CRE industry to bring back some more normality to the market and the restabilization will increase from there,” Ghori said. “The next two years are going to be a really disruptive time for CRE, but it’s also going to be the beginning of green shoots and will help to stabilize the market, and hopefully we have a bottom that we can start recovering from.”

Andrew Coen can be reached at acoen@commercialobserver.com