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CRE Stress
This week, the Federal Reserve threw the markets into a frenzy, lowering estimates for how much it could cut the federal funds rate next year while cutting the current rate by a quarter of a percentage point. The Federal Open Market Committee anticipated two rate cuts next year, projecting a median 3.9% fed funds rate in 2025, higher than the median of 3.4% projected in September.
But some borrowers will face stress, whether the Fed cuts rates two times or four times. A recent study from the research firm Trepp found even significant cuts in interest rates won’t eliminate commercial real estate borrower stress. Treasury yields, to which CRE loan rates are indexed, move based on additional fiscal risks, not just the Fed’s actions.
Also, CRE delinquencies overall continue to rise, especially in office and multifamily properties, says Rachel Szymanski, chief economist at Trepp. Office property cash flows are down due to work-from-home trends, and property values have also fallen, so some borrowers will fail to meet critical underwriting criteria to refinance those loans.
To get a new loan or refinance, CRE borrowers need to show they have cash flow to cover debt payments, known as the debt service coverage ratio. Typically, net operating income should exceed debt payments by 1.25 times or more.
But Trepp found that even in a 5.5% rate environment, 17% of maturing office loans by year-end 2026 would have debt service coverage ratios of less than 1.25 times. The firm studied $100 billion worth of so-called conduit commercial mortgage-backed securities — loans bundled into securities and sold as bonds — that will mature by 2026. The weighted average loan interest rate on office properties in 2024 was 7.03%, according to Trepp, up from 4.02% in 2022.
Also, CMBS lenders are demanding 50% to 60% loan-to-value ratios on loan originations compared to 55% to 65% in 2020 and 2021, Szymanski says.
Banks tend to have even tighter underwriting standards for loans that stay on the balance sheet versus those sold as CMBS, she adds.
While that should be good for credit quality, and lower rates may reduce some stress on borrowers, there are complex dynamics that will force banks to make difficult decisions in the months ahead when it comes to stressed borrowers.
• Naomi Snyder, editor-in-chief for Bank Director
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