Why Interest Rate Cuts May Not Be A Cure-All For What Ails CRE Lending

As investors anxiously await the Federal Reserve's move next week, fund strategists, heads of investment firms and bank executives are girding for an economic slowdown if not an outright recession. 

Much of the commercial real estate sector is pinning its hopes on a rate cut unlocking credit markets, but lenders today are more concerned with shoring up their own balance sheets than they are in underwriting new debt. 

“I am concerned about the next six to 12 months, and I think businesses have to be ready for that,” said Gareth Soloway, the chief market strategist at Verified Investing.  

Delinquency rates continue to rise, and “these are little breadcrumbs that are showing that things are changing, they're just not at that break point yet,” he said.  

The comments were made during Fort Lauderdale-based Optimum Bank’s Virtual Banking Conference Thursday morning, where a dozen financial insiders gathered to give their perspectives on investment strategies. 

The mood permeating the conference was uncertainty, anxiety and pessimism about the U.S. financial system.

Capital underwriting for commercial real estate could loosen if the Fed follows through on the consensus plans for rate cuts, but those cuts won’t occur in a vacuum. There’s still a real possibility of broader macroeconomic headwinds, ranging from a weaker dollar to a negative turn in labor markets, and banks have in turn continued to shore up reserves, panelists said. 

Roughly $1T in commercial real estate debt is slated to mature in the next year. Banks wrestling with uncertainty in other sectors while facing increased scrutiny from federal regulators may not rush to open their commercial lending book to fill that gap, said Nathan Stovall, director of research at S&P Global Market Intelligence’s financial institution group. 

“As that paper is coming due, we’re seeing tremendous scrutiny from the regulators in the investment community, and you're seeing loan growth there really slow,” Stovall said. 

The wall of maturities that has loomed over the commercial real estate market continues to grow as sponsors take short-term extensions, bridge loans or find other ways to delay refinancing at today’s rates. 

Most of what’s coming due is five-year balloon mortgages originated between 2018 and 2020 when carrying rates were around 3%, said Rebel Cole, a professor of finance at Florida Atlantic University. The best those sponsors can hope for in the short term is to refinance at between 7% and 10%, he said. 

“It doesn't matter if you're in Florida, it doesn't matter if you’re an industrial property, it doesn't matter if you’re 100% leased. When that mortgage goes from 300 basis points to 800 basis points, that property is most likely going to foreclosure,” he said.

The National Federation of Independent Business’ Small Business Uncertainty index is 92, its highest level since October 2020, with 24% of owners continuing to report that inflation is their top concern. 

That uncertainty, coupled with other weak economic indicators, is “screaming that we’re headed towards a recession,” Cole said. 

While not every panelist was ready to predict an outright downturn, none expressed optimism around near-term economic growth. Most said a period of persistent low growth likely lies ahead, largely due to the deficit spending that has dominated U.S. budgets for over a decade.

Sheila Bair, former chair of the Federal Deposit Insurance Corp., and several other speakers said the Fed’s monetary policy toolbox cannot compete with the last decade of expansionary fiscal policy, with government spending helping to fuel inflation. The problem will likely get worse before it gets better regardless of who is in the White House.

“The consensus projection is 25 basis points next week, with two more 25 basis point cuts before the end of the year,” Bair said. “I think 75 basis points total by the end of this year is likely, but I will take a wait-and-see posture on further cuts next year, mainly because I think the continuation of fiscal inflationary pressures will increase and that's regardless of who is elected president.”

However, she and other economists have said there’s a case to be made that it’s still too early to cut rates. 

Numbers released Wednesday show annual inflation slid to 2.6%, the lowest level since February 2021, and recent jobs reports data has been weak. But the Fed has signaled for over a year that its target inflation rate is 2.0% so, the argument goes, there is still work to be done. 

The counterargument is that the topline numbers fail to capture weaknesses — like lower spending for low-income earners, or the shift of labor from full-time to part-time positions — that signal that it’s time to cut rates, panelists said. A failure to move now, and perhaps with haste, could lock the economy into a recession. 

Expectations are that Powell is aligned with the monetary doves for the first time since the Fed began raising rates, that the likely first cut would signal many more to come and that it all will help unjam the capital markets. 

Bair had a word of warning for lenders calling for the Fed to pivot. 

“Traditional lenders should be cautious about adding their voices to the Wall Street clamor for big cuts,” she said. “To be sure, those who have unrealized losses on their securities portfolios will see a nice boost in the value of those assets, but their core business could be challenged if the Fed goes too fast.” 

“With big rate cuts, your loan yields may well go down, but you will still face significant competitive pressure on the rates you have to pay on deposits,” she said.