There’s an awful lot of happy talk going around about 2026. Apparently, that’s the year we were supposed to stay alive till. I surely hope the talk is right, even if it doesn’t rhyme. 2025 was a pretty darn good year for commercial real estate but underperformed the “talk” in late 2024. We like happy talk. I keep seeing stories across the media landscape about how asset values are going up, transaction volume is increasing and we’re finally out of the woods. Put on your party hats, spike the punch and let’s rock’n’roll.
This whole happy edifice appears to be built upon the prospects of materially lower interest rates next year coupled with solid growth. I just can’t see that happening.
Do we really think that interest rates are coming down, while a strong economy will continue to push up rents and depress cap rates? Do we really think inflation will moderate while revenues continue to grow (and oddly, expenses don’t keep pace…but that’s another story)? Of course, spreads will come in because everyone will be so excited about the great times ahead of us – higher valuations, higher net income, lower coupons. Cue the halcyon days memes.
The certainty bugs me. The only absolute certainty I can see in economics and frankly in almost anything, is that whatever you think is certain, is probably not. Indeterminacy is the only ineluctability. Check in with your flat earthers, global cooling, peak oil and cold fusion friends out there. How’s that worked out?
When you listen to the business shows in the morning, everyone is absolutely certain about almost everything. I guess that’s the reality of television, you don’t get to talk to Becky, Andrew and Joe if you say “maybe” a lot. Hair on fire gets clicks, hair on fire gets you booked. But all that hyperventilation suppresses thoughtful discourse and debate…which we could really use right now.
The problem here is that there are so many factors that influence interest rates and the shape of the yield curve in 2026, factors that are themselves not fully understood and are often in conflict. Sure, you can pick your facts and then get to the conclusions you want, but that’s an economic version of show me the man and I’ll show you the crime. It’s hard to sort out where all this goes when a factor that (potentially) impacts interest rates in one direction has concomitant knock-on impacts which might drive interest rates in another direction.
The elephant in the room is, of course, our federal debt. Our federal debt is over $38 trillion right now, and it probably went up about a billion dollars or so as I dictated that sentence. Total governmental debt is in excess of $44 trillion. Debt service on just the federal component of our debt consumes 17% of our budget and that’s about equal to our national GDP. By the way, only funny accounting excludes from those numbers approximately $7 trillion of Fannie and Freddie debt and a couple of billion dollars of student loan debt to boot.
Other countries might have a worse fiscal outlook; maybe we’re the best house on the street but perhaps that’s only because we own the world’s reserve currency. Nonetheless, government debt, which is the end product of government spending, is fundamentally inflationary and our reserve currency status won’t bail us out forever. This debt overhang represents a constant, irresistible pressure on the cost of money, I know that there are academic economists (and certainly politicians) out there who tell us to ignore the debt, tell us that there is no nexus between debt overhang and interest rates. But come on, folks, even the noisiest acolytes of that particular religion can’t suppress the occasional eye roll when they think no one is looking.
We can take a lap for getting inflation down from almost 9% to 3%, but the Fed, at least, continues to pretend that they model the economy in expectations of inflation as 2%. It has been and remains persistently close to 3% which, for the mathematically challenged, is 50% higher than the 2% target. There’s more than a passing suspicion out there that 3% is the new 2%. That suspicion is bolstered by the fact that we are about to have a new Fed chair and given what we have been hearing from the White House pretty consistently, it’s a good guess that with the new chair, the doves will take flight. That means that unless we get a couple of truly horrific prints on the marque inflation numbers, Fed Funds is going done, probably towards the bottom of the dot plot range.
But hang on a minute, a lower cost of money is good, right? Borrowing costs will come down just like the optimists among us have promised. Regrettably, that’s probably only going to push down the short end of the curve and might that in of itself be the cause of a new burst of inflation?
Inflation can be an input as well as an output. Inflation expectations can cause the Fed to push Fed Funds up. Reducing Fed Funds can trigger a return of inflationary expectations. The neutral rate of interest, the rate which is neither stimulative nor restrictive, is something between a unicorn and a chimera. We’re going to miss one way or the other. Inflation will not only persist but might begin to grind up if the economy performs well above long term trend while interest rates remain accommodative., (Such negative nattering is apparently impolite these days). Professor Google tells me that almost never have interest rates much declined during periods of strong and sustained economic growth.
Moreover, while the Fed exercises considerable influence and some control over the short end of the curve, it has little or no control over the long end. Generally, the bond market (which is bigger and badder than the Fed) drives the long end based upon supply, demand and inflation expectations. The Fed has apparently recommitted to QE and is again buying long-dated bonds. (The effort is apparently tied to technical issues around balance sheet, but that sounds like cover for shoveling the proverbial…against the tide effort to restrain the ten year.) The ten year historic average is 4.25% and that has persisted through long periods when annual growth was around or just under 2%. If we start to grow above that growth trend line, do you really think inflation is going to go down? Driven by growth prospects and an enhanced uncertainty premium, the ten year will have a bias towards increase not decrease as the economy remains hot.
Remember, while lowering Fed Funds will provide for a lower SOFR, it’s clearly not certain to affect the long end and it’s the ten year that largely drives valuations and cap rates.
Is there a way for the economy to grow above trend without the sort of customary pressure we see that drives interest rates out? AI to the rescue? It’s theoretically possible that AI turbocharged with some magical thinking, will cause productivity to be so strong that the economy can expand well above trend without succumbing to inflationary pressures. Possible but an inside straight sort of bet.
As I was writing this the Fed, evidencing a significant amount of internal conflict, embraced another 25 bps cut to Fed Funds and coupled that with a warning that future cuts to Fed fund rates are not a certainty. A push-pull sort of messaging that calmed the Street before and probably will, at least in the short term, for a time.
The Fed’s job going into 2026 is hugely difficult. There will be pressures from the White House that will be difficult to withstand. They will need to think about the debt and the deficit. They will need to think about the impact all this has on employment (does employment still trump inflation? I think so, for a while). They have to think about the value of the dollar and inbound investment. There’s always some lingering concern about impacting our reserve currency status. If interest rates get pushed down low, the boomers have a savings problem and the folks don’t like that much. If interest rates keep moving around, that market volatility produces some fragility in our markets and impacts liquidity, not a good thing. They have to worry that the economy will get too hot and inflation will come roaring back faster than they can attempt to mediate it. They have to worry that lower interest rates will impact the profitability of our banks. The housing market is going to scream like a stuck pig if the long end and mortgage rates stay elevated. But pushing short term rates further down to fix the long end is like pushing on a wet string. There’s a lot going on as 2026 unfolds and how the Fed will play its role is far from clear. While the political bias might be toward continuing to push rates down chasing one’s theoretical neutral rate, the data is going to get in the way. Is the Fed is free to always choose its own facts?
And we haven’t even talked about geopolitics, black swans and all that other stuff that generally makes for an entertaining news show, but a bad economy, where risk off and inflation battles for control. Stagflation anyone?
You get to pay your money and take your chances, but I personally can’t see the ten year coming down inside 4% on a sustained basis absent a raging recession (then all bets are off). I suspect that early in the year the Fed will push Fed Funds inside the mythical neutral rate. At best that means a steep yield curve and at worse, a new bout of inflation. Frankly, one way or the other, something above a 4 1/2% yield on the ten year some time in 2026 looks to me way more likely than something under 3 1/2%.
What’s this mean for all of us in CRE-land? At best, we’ll likely have a dual speed commercial real estate economy. We’ll have a pretty good year in the new loan origination business (at least in floaters and short-term SASBs) refinancing broken toys after they’ve been repriced and doing new deals which can comfortably tolerate the interest rate environment. But let’s not fool ourselves about how income will go up faster than expenses. While it may be true in some geographies and some asset categories, it’s hardly the stuff of baseline assumptions (like it is so many broker packages these days).
And while we’re busy in the new origination market making some of the best loans that we’ll make in the next several years, it will finally be time to embrace those distressed debt strategies.
The level of default and distress as reported by Trepp in the securitization business continued to creep up. On the bank side, it’s more opaque as trouble doesn’t show up as NPLs but as modifications, and now even modifications fall out of the data after a year. I thought we swore a blood oath to transparency? Apparently, that only applies to the good stuff. I note that Fitch now sees a deteriorating 2026 outlook for CMBS as well as other asset categories. It cites the debt and other broad macroeconomic factors for its view. Is this suggestive that the vulnerabilities of the CRE economy are more than is apparent even to worry warts such as I?
Data suggests we “modified” around $600 billion of loans that were otherwise due to mature in 2025. Nice way of saying we did stuff to avoid loss recognition. While extend and pretend might be unduly uncharitable, it wouldn’t be wrong. There’s about $900 billion of stuff scheduled to mature in 2026. While math can be complicated (at least for me), $600 billion plus $900 billion equals $1.5 trillion. That’s a meaningful amount of commercial mortgage debt, much of it plagued by significant mispricing issues, which need to be resolved before our dalliance with the zero bound interest rate environment can be entirely put in the rear view mirror.
Good deals will get done, but a $1.5 trillion legacy book of broken toys and damaged assets which we had been hoping against hope would be significantly diminished by now, will weigh on the economy. The extend and pretend game will finally end as it becomes increasingly apparent that there’s no prospect of cheaper money to make these problems go away any time soon. Less pretend, more actual resolution. For those looking for good news, we can focus on the fact that most (most?) lenders are reasonably well capitalized and there’s enough capital on the equity side looking to be put to work to get many of these assets comfortably refinanced (not so comfortably for the over-levered existing owners) during the next couple of years. The government is not going to have to smash the break only in emergency policy toolbox glass…arguably. Hopefully, we won’t reprise the GFC, but the distressed overhang is real and needs to be worked through. Pain for some and great fun to those flying the Jolly Rogers, but all this repricing and recapitalization will remain a drag on the broader markets and valuations. Asset values will not rebound as fast as the optimists believe (or at least as they say they believe) until the zombie cohorts have been eliminated.
All in, that makes for a pretty interesting and largely profitable 2026, but it’s pretty clear to me that we’re not going to outperform our current sunny expectations and there’s some real risk from material underperformance.
Gives me something to write about.