Last month, the Federal Reserve received the data it was looking for.
Inflation cooled and unemployment rose – a sign that the labor market may be normalizing.
The markets assume that the indicators will prompt the central bank to finally lower the key interest rate.
The key question in the commercial real estate sector, however, is whether interest rates will fall far enough and quickly enough to allow insolvent borrowers to refinance.
The short answer is: It depends. The London Stock Exchange Group has proposed three different scenarios for how the federal funds rate – currently 5.25 percent – might evolve.
“The contrast between the three scenarios is stark,” write the report’s authors, Robin Marshall and Luke Lu, who used yield book data on fixed-rate CMBS loans for their analysis.
What is clear, they said, is that the Fed’s course could be crucial for about half of the CMBS loans due in the next two years – a total of $89 billion.
The best case scenario for borrowers and the economy is what LSEG calls a “more normal rate cut cycle.” It is similar to ING Bank’s best case scenario, which the company believes is 50 percent likely and is already priced into the market: 100 basis point cuts by the end of the year.
In the “normal” scenario, the Fed cuts interest rates by 50 basis points every quarter – that is, 25 basis points per meeting. In the second quarter of 2025, interest rates would fall to 3.75 percent and a year later to 1.75 percent.
This is a rosy outcome for CMBS borrowers.
Sponsors who remortgaged in the past month borrowed at an interest rate of around 7 percent, compared to around 4 percent 10 years ago, according to LSEG. At the higher rate, many properties cannot meet the debt coverage ratio (income compared to mortgage payments) required for remortgage. That’s why the “failure rate” for remortgage is 47 percent.
However, if interest rates fall by 325 basis points over the next two years (the “normal” scenario), the default rate on refinancing will fall to 13 percent, according to LSEG.
Worst-case scenario
The worst outcome for borrowers would be if the Fed sticks to its “higher interest rates for longer” strategy.
In this reality, inflation remains stable, employment high, the economy strong, and Fed Chairman Jay Powell will remain conservative in his rate cuts. The LSEG forecasts that rates will be cut to 4.5 percent in mid-2025 and 3.5 percent in mid-2026.
If the “higher rates for longer” situation occurs, only $3 billion of maturing loans will be saved by rate cuts and another $7.3 billion by forbearances. That leaves nearly $31 billion of maturing debt that will dry up. The default rate is 35 percent.
The third scenario is a double-edged sword.
If the economy were to suffer a shock, LSEG predicts that cuts of up to 100 basis points per quarter – 50 basis points at each Fed meeting – would be “entirely plausible”. In this case, the benchmark interest rate would fall to 0.25 percent by the second quarter of 2026.
For commercial real estate borrowers, such a drastic reduction would be life-saving. Only 5 percent of sponsors would not be able to refinance their loans, the LSEG predicts.
But this would also bring bad news. Such drastic cuts would only come about if the Fed were responding to a recession that would weaken demand for all asset classes and thus put pressure on owners’ net operating profits.
Conclusion: The next three months are critical for commercial real estate borrowers with expiring loans.
The Fed’s next steps are still a big unknown. It’s possible Powell will provide more insight this week at the Kansas City Fed’s annual meeting in Jackson Hole, Wyoming. At least that’s what economists are hoping.
The headline of the ING report sums it up best for now: “More twists and turns are ahead.”
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