The commercial real estate industry, already burdened by the lingering effects of the COVID-19 pandemic, is now facing a critical period as interest rates start to fall. For many property owners and investors, the Federal Reserve's recent rate cuts offer a glimmer of hope. Yet, for others, particularly those holding significant debt, this relief is arriving too late.
One stark example of this trend is the story of 145 South Wells, an office tower in downtown Chicago. This property, completed in January 2020 by Daniel Moceri, a security entrepreneur turned developer, was hit hard by the pandemic's impact. Just months after its opening, demand for office space dried up, and by late 2023, the building's major tenant, a co-working company, vacated the premises. Adding to the woes, the interest rate on the loan backing the property surged to over 10%. By July 2024, Moceri and his partners had lost the building to lenders.
This scenario isn’t isolated. Many commercial property owners across the U.S. took advantage of historically low interest rates in the years preceding the pandemic, loading up on debt in hopes of capitalizing on favorable market conditions. However, when the Federal Reserve began aggressively raising interest rates in early 2022 to combat inflation, the cost of borrowing skyrocketed, leaving many property owners unable to meet their debt obligations. While the Fed has now started to cut rates, for some, like the owners of 145 South Wells, the damage is already done.
The Rate Cut: Too Little, Too Late?
Last week, the Federal Reserve cut short-term interest rates by half a percentage point, signaling potential relief for commercial real estate owners. This move follows weeks of declining commercial mortgage rates as markets anticipated the Fed’s intervention. For the commercial property market, which has struggled with sinking valuations, stalled sales, and refinancing difficulties, this rate cut offers a lifeline. More than $2.2 trillion in commercial property debt is set to mature between 2024 and 2027, according to data from Trepp, a real estate analytics firm. Many borrowers are hoping that lower rates will help them refinance their debt and avoid foreclosure.
Tom Shapiro, president of GTIS Partners, a real estate investment firm, expressed cautious optimism about the rate cuts. "This will help a lot," Shapiro said. "It makes people feel better about a soft landing." However, while the Fed’s actions may help stabilize the market in the long run, the relief comes too late for some highly leveraged property owners, like those at 145 South Wells, whose lenders have run out of patience.
The Growing Distress in the Market
Securitized commercial property loans have been particularly vulnerable to the recent market turmoil. As of August 2024, distressed loans — those that are either delinquent or have been transferred to special servicers for resolution — amounted to $39.7 billion for fixed-interest loans and $27 billion for floating-rate loans, according to CRED-iQ, a real estate analytics firm. These distressed loans represent only a fraction of the total commercial mortgage-backed securities (CMBS) market, but they highlight the growing financial strain on property owners.
One factor contributing to the distress is the significant number of property owners who took out floating-rate loans. Unlike fixed-rate loans, which remain stable over time, floating-rate loans rise and fall with broader interest rate changes. Property owners who took out these loans when rates were low found themselves "getting clobbered" when rates soared in 2022 and 2023, said Mike Haas, CEO of CRED-iQ.
The situation is particularly dire for landlords who own properties in sectors that have faced long-standing structural challenges, such as office buildings and regional malls. The value of commercial real estate loans in foreclosure nearly tripled between January and August 2024, reaching $19.2 billion, according to CRED-iQ.
The Tides Equities Example: A Struggling Multifamily Landlord
The multifamily sector has not been immune to these challenges, as demonstrated by the struggles of Tides Equities, a Los Angeles-based apartment landlord. Tides made headlines over the past decade for its aggressive acquisition strategy, purchasing over 100 low-rent apartment buildings across the Southwest. The company, which emblazoned its name on its properties, aimed to renovate the buildings and raise rents, sometimes by hundreds of dollars per unit. This strategy worked well when interest rates were low, and rent growth in cities like Phoenix and Dallas was strong.
However, when interest rates began to rise, Tides’ heavily leveraged portfolio came under immense pressure. The company, which had taken out floating-rate loans to finance its acquisitions, saw its debt costs soar. At the same time, rent growth slowed in many of its key markets, and tenants began struggling to keep up with the higher rents. By 2024, around a dozen Tides properties had entered foreclosure or a similar process, and a handful had already been turned over to lenders.
One of Tides’ now-foreclosed properties in Austin, Texas, serves as a cautionary tale for multifamily investors. In early 2022, Tides took out a floating-rate loan worth nearly 91% of the property's value, putting it at high risk for default. As Morningstar, a ratings company, noted in a 2022 report, Tides’ reliance on continued rent appreciation made the company vulnerable to any weakness in the rental market. When rents failed to keep pace with rising debt costs, the property was eventually taken back by the lender.
Hotels: A Different Kind of Distress
The hotel sector presents a different, but equally troubling, set of challenges. Hotel owners like Ashford Hospitality Trust saw floating-rate debt as a relatively safe bet, assuming that rates would fall during economic downturns. However, the pandemic upended this assumption. While interest rates did initially fall in 2020, they began to rise sharply in 2022, just as the hotel industry was starting to recover. By mid-2023, the interest rate on one of Ashford’s loan portfolios had nearly doubled, reaching close to 9%. The company found itself with a portfolio of 14 hotels that were worth less than the total debt owed on them.
Stephen Zsigray, Ashford’s CEO, described the difficult decision the company faced: default or continue making payments on properties that were already underwater. Zsigray said the company ultimately decided that "throwing good money after bad" wasn’t a sustainable strategy.
Looking Ahead: A Fragile Recovery
As interest rates continue to fall, some commercial property owners remain hopeful that they can hold on just a little longer. Michael Lavipour, an executive at lender Affinius Capital, suggested that lenders may be more forgiving of landlords now than in years past, recognizing that many of the financial challenges property owners are facing stem from the pandemic, a completely unforeseen event. "Lenders don’t think it’s the [borrower’s] fault," Lavipour said.
Still, the outlook for commercial real estate remains uncertain. While lower interest rates may provide some relief, the fundamental challenges in sectors like office buildings, regional malls, and hotels persist. For investors, the coming years will be a delicate balancing act of navigating these risks while identifying opportunities in distressed assets.
The story of 145 South Wells is a reminder that, even with rates falling, not every property owner will survive this turbulent period. As the commercial real estate market adjusts to the post-pandemic world, the ability to adapt quickly and manage debt will be key to success. For some, the rescue is already too late.
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