Doesn’t all the happy talk about the state of the commercial real estate economy seems a bit overdone? Transactional volume is rebounding, asset prices coming back, cap rates stabilizing, interest rates coming down, spreads coming in, etc., etc…sunlit uplands as far as the eye can see. There is a smaller rump of pessimists out there, wringing their hands about inflation and growth, albeit they seem rather lonely.
In any event, it’s absolutely clear that all will be fine sooner or later. It always gets better eventually, doesn’t it? As I learned early from one of my economics professors, it’s important as a professional bloviator to remember to predict what or when, but never what and when (just in the unlikely case someone remembers what you said when what or when occurs).
I’m pretty sure about the what, less sure about the when. Rent growth will return, the relationship between coupons and cap rates will facilitate positive leverage and assets will again be right-sized. But along the way, even if the fine economy predicted for the first quarter of ’26 actually arrives, there will be some potholes along the highway to frolicking good times.
We were told over a year ago interest rates were coming down…a lot, and we bought it. We continued to buy it even when the Fed refused to lower Fed Funds. We bought it even while CRE transactional volumes didn’t rebound strongly in the first quarter and barely creeped back in the second. Every time SOFR or the ten year creeps down a couple of basis points, we pop the champagne cork. On the day I began writing this, we got a whopping 25 bps cut in Fed Funds. What happened? SOFR barely twitched, the ten year yawned (and actually moved out a bit). If this was supposed to trigger good times, it rather underperformed.
Inflation remains stubbornly high and stagflation fears continue to pop up in a whack-a-mole sort of way driven by a plethora of often conflicting headlines in our 24/7 news cycle. Core year over year inflation is 3.1% (based on the September reports) and 2.9% month over month. That’s not terrific unless we give up entirely on 2% as the Feds’ goal and declare victory, proclaiming 3% as the new black.
On the other hand, the BLS smacked us up against the side of the head a few weeks ago with a massive million dollar downward adjustment in jobs (notwithstanding Mr. Trump’s efforts to will or suborn a better outcome). While that data doesn’t scream recession, it certainly doesn’t scream wild ass growth, does it? Consensus GDP projections for 2025 is only 1.5%. That’s really not terribly supportive of the case for robust growth coming soon, is it? A whiff of stagflation in the air? Some will see it. In a Schrödinger’s Cat sort of way, we won’t see how all this works out until it actually works out, which is a little late for thoughtful planning.
Everything is so interconnected, so interdependent (OMG is this financial intersectionality?). If inflation were to begin to march downward, then Fed Funds could chase it. Lower interest rates would be terrific for our business, right? But that begs the question, why would inflation be coming down? If it was because of worries about recession or stagflation, that’s not great. Such a suppression of the yield curve can be a self-fulfilling prophecy. While perhaps the cost of leverage would come down, net incomes would also probably stall as rental income becomes restrained, while operating costs might stubbornly refuse to play along.
The smart money says that Fed funds are coming down and the economy will be doing great in 2026. The first half of that is rather baked in the cake, isn’t it? We’d all be enormously surprised if the Fed doesn’t delivery two, three or even more rate cuts in the next half year or so. The second half that the economy will do great in 2026 is less certain. I rather agree with that (albeit let’s remember that history suggests smart money is right less than half the time.)
So, let’s take a look at the smart money’s view of 2026. A good economy ensues. Inflation? We’ll probably agree that 3% is the new black. Interest rate environment? Unless the Fedheads change course radically in the new few months, Fed funds will be considerably lower by Q1 2026 than they are today. Notwithstanding, suppression of the short end of the curve only means that we will be confronted with an increasingly steep yield curve. It’s hard to see the ten year breaking out of a range of 4-4.25% and let’s be clear, the Fed really can’t control the long end. Maybe the Fed can try a bit more of QT and work the twist strategy a bit harder, but out at the ten year mark, investors rule. Investors want, and are likely to want for a considerable period of time, a meaningful premium for duration.
What does all this mean for commercial real estate and for commercial real estate finance? Growth is good. That’s true even if growth means interest rates stay elevated (certainly compared to the zero bound world of the past decade). That environment is probably just fine for deals on a go-forward basis as revenues outpace costs and stabilize DSCR and Debt Yields make fresh financing possible.
But every silver lining has a dark cloud. Regardless of whether we indeed are entering a new period of vigorous growth or the worries about stagflation or recession turn out to be unhappily prescient, the pool of assets financed at or near the zero bound or financed against a low coupon ten year will remain under considerable pressure. Remember, Fed funds was less than 2% from 2008 to 2022 and often near zero along the way. The ten year was well before 4% during this entire period. Through most of this time, spreads were shockingly tiny.
In a good economy, that pressure will come from relatively elevated coupons. In a bad economy, it’ll come, well, it’s a bad economy, stupid. Remember that for assets that have been limping along for several years, underinvestment in CapX is real and this will impair the value of these assets, even in a good economy, until they are repriced and in the hands of new ownership who can justify investing significant fresh equity.
We continue to stare at a wall of maturities over the next 18 months in which something in the $200+ billion plus range is materially mispriced.
Fresh equity will not flow into these assets until they are appropriately valued and priced. Don’t get me wrong, this will happen, but…ouch! It will be painful for legacy ownership while more amiable for those on the pirate ships of distressed debt investors. Can we fix this problem like we always have in the past with can kicking? It certainly worked for years. Extend the maturity for a bit of fresh equity or covenant tightening, even if it all might be mistaken for a fig leaf and hope for the best. There is considerable evidence right now that this strategy is getting close to the end of its useful life. In the here and now, there are many indications that the banks and non-bank lenders are just about at the end of their enthusiasm for can kicking. Why? First, they don’t see with clarity a time when these assets will return to par. Moreover, balance sheets across the lending marketplace have been somewhat repaired and lenders increasingly deem themselves sufficiently well capitalized to accept taking losses, enjoy a kitchen sink quarter, and move on.
We don’t evade the shock of resolving our legacy book unless both the short and long end of the curve comes down while the economy booms. That’s a needle’s eye for a chubby camel that’s not likely to present. So, whether the economy gets better or worse (I think better), we’re going to have to reprice a huge number of commercial real estate assets over the next year. Repricing a significant number of assets will have a knock-on effect on the value of commercial real estate in general and continue to suppress cap rates, slowing the pace of recovery. Moreover, it’ll have a further knock-on effect through impairment of the balance sheets of the banks and lending sectors, which will shoulder the losses as excess capital is eaten up through realized losses, again, sand in the saddlebag of our recovery.
And if you can’t abandon your God-given pessimism (and we’re all optimists in real estate, right?), please feel free to worry that this loss recognition problem might also begin to impair our robust warehouse lending market which has been the engine of growth for the non-bank sector for the past several years. Money-center banks have lots of opportunities to deploy their capital and have almost no sense of humor about the losses that might flow from the real estate sector. If all this begins to suppress warehouse lending, all the problems of our sector will be magnified.
We’ll ultimately reacquire a balanced and healthy market, but the path to such an amiable future will be painful. High growth together with higher coupons or low growth, together with reduced net income, both will require reckoning with a large pile of mispriced assets. As Warren Buffet famously said, “When the tide goes out, it reveals who has been swimming naked,” and the tide is about to go out.
For the piratical, regrettably, it seems to me that normalization will be a slow burn. Harvesting outside economics from this part of the cycle will be harder than was probably envisioned, but stay the course because economics will be there.
Let’s be realistic about all this. Stay Alive Till ’26 is probably still a pretty good mantra. I generally come down the side of the bulls in this respect. A lot of legacy assets will be fine and will refinance at or close to par without significant distress. New deals will be fine. Transactional activity will be up as the economy continues to grow. Nevertheless, the CRE economy won’t return to robust good health until all the legacy book is resolved. Regardless of whether our economy goes up or down, regardless of whether coupons come in or go out, the resolution process will be painful for those without bathing suits and in any event will take considerable time. This pain is baked into the cake.
Can we try out Stay Alive till ’27?