Rate Cuts Won’t Save D.C.’s Distressed Offices, But Troubled Apartment Owners Get A Reprieve

The commercial real estate industry breathed a collective sigh of relief after the Federal Reserve announced a 50-basis-point interest rate cut Wednesday, and now individual markets are determining what it will mean. 

In D.C., a market that has faced especially high distress in its office market and growing issues in its multifamily sector, the rates are expected to unlock liquidity and move more deals across the finish line. That may be enough to rescue many multifamily properties that only had financial challenges, but for the structural issues that many office buildings face, executives say it won't move the needle. 

“We’ve been talking about this for a couple years, ‘When is this going to happen?’” Solitude Cove Capital Managing Principal John Kevill said at Bisnow's DMV Capital Markets event Thursday morning. 

“I think a lot of it’s psychological in the short term,” Kevill said, adding that rates coming down is "going to give people a growing amount of conviction that if they make move, things aren’t going to get a ton worse — in assets that aren’t office."

D.C. has been deemed the "ground zero" for office distress, with Trepp finding it has the highest share of office loans at risk of default of any major U.S. city. Many buildings to sell over the last year have traded for less than 40% of their prior prices, a value loss that has wiped out many equity investors and led banks to take back a growing number of buildings. 

“Rate cuts won’t save bad office buildings,” PRP Director of Acquisitions Tom Wasko said. “I think it's good for the overall market. It will bring back some liquidity ... But 50 basis points or however many it may be in the end doesn't save a certain segment of the market." 

Many banks have sought to reduce their exposure to office in recent years, and it's unlikely this week's cut, and even the 50 additional basis point reduction expected by the end of this year, will have any impact on lenders' appetite for the office sector. 

“There’s a lot of headwinds that I don't think short-term interest rates are going to fix on the office side in D.C.,” MRP Associate Vice President Nick Gordon said. 

“As far as the investor and the lender community. I think there has to be a bigger reset in perception of office as an asset class,” Morning Calm founder Mukang Cho said.

Moreover, any benefit to the office market to come out of the shifting rate environment has already been priced in. Traditional office acquisitions are priced on the five and 10-year treasury yields, which factored in the rate cut ahead of the Fed’s announcement. 

The Fed’s rate has a greater impact on short-term debt and floating-rate loans — like those for construction.

The multifamily sector in D.C. saw a surge in new construction starts in the early part of the pandemic when interest rates were near zero. But the rate hikes put many developers in a difficult financial position, with some new apartment buildings in hot neighborhoods suddenly having distressed capital stacks and going into foreclosure. 

This week’s cut is a first step in reversing some of that distress. 

“It'll have a positive effect on newer multifamily developments because those deals were put together in the lower interest rate environment. And in that lower interest rate environment, we were all probably a little more aggressive than we could have been with how much debt we put on or allowed to be put onto a property,” EagleBank Chief Real Estate Lending Officer Ryan Riel said. 

With rates coming down, Riel said, rescue capital is poised to jump into the market and help bail out some of these new multifamily properties that obtained floating-rate construction loans at the wrong time. 

For HH Fund Managing Director Lee Chen, whose firm acquired a Union Market apartment building at a foreclosure auction in May and has looked for other distressed deals, that means more competition. 

While much of the sector has been in a “waiting game,” he expects the rate cut will lead transaction volume to pick up next year. 

“It’s going to drive more demand for buyers and also sellers,” he said. 

The rate cut also helps push along new development that has been sitting, shovel ready and waiting through the period of elevated capital costs.

MRP’s Gordon said that if the treasury yields and short-term rates continue to dip, the firm can start looking at starting construction again, moving forward some of their multifamily projects that have been waiting. 

“It’ll hopefully provide a window for us to get started on some of the deals that we've spent a lot of money and time getting shovel ready,” he said.

Where that new development potential may help the office sector is with conversions.

The decreasing cost of money for construction means that some office-to-residential projects that have been on the cusp of penciling may finally be viable. 

Douglas Development Corp. Managing Principal Norman Jemal, whose firm has two conversion projects underway, said he expects to see more move forward soon.

“I'm of the belief that lower interest rates will allow more of these buildings, these office buildings in Washington and the metro area to be redeveloped into other types of uses, cull the herd, so to speak, and create a lower vacancy and healthier market," Jemal said. 

Douglas' projects are both in Georgetown, an office-to-hotel project at 1023 31st St. NW and an office-to-residential at 2715 M St. NW. He said they were both “substantially vacant” and “functionally obsolete.” 

“I’m not the only one doing it and it won’t be the last,” he said. 

The opportunity to convert is one that has enticed D.C. elected officials as well as real estate leaders as they think through what must be a major repositioning of D.C.’s central business district. 

The mayor’s office this month awarded its first three 20-year tax abatements to office-to-residential conversions downtown. This summer, the city launched an office-to-anything program offering a 15-year temporary property tax freeze to qualifying repositionings. 

But rate cuts won't be a cure-all to make the conversion projects pencil, Riel said, as the biggest challenge with these projects has never been the cost of capital.

“It is the feasibility of the conversion itself, and typically that's physical limitations," he said. 

While there is hope for money coming back into the sector, opening up the markets and allowing a necessary reset of the commercial real estate landscape, market players expect the adjustment will be slow.

It will take a while for the changes to work their way through the system, with traditional lenders still reeling from the dramatic shifts to the commercial real estate market over the last few years. 

“A lot of lenders, especially the smaller regional banks, have an outsized exposure to commercial real estate loans, period,” Cho said. “A lot of those banks are really looking to do addition by subtraction by laying off the loans that they currently have on their books before they can even think about originating loans.” 

Still, Wednesday's move brought hope to the horizon. 

“The psychological impact, the optimism that I think we’ll feel in the market over the next period of time, it lets us wake up a little lighter every day,” Riel said.