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High Interest Rates Prompt Investor Retreat—Is a Financial Bust Imminent?

Updated: Jul 7

 

The recent surge in interest rates has left seasoned commercial real estate owners struggling. It’s a significant challenge for landlords of office and retail spaces who were unprepared for this shift, endangering the entire real estate market in the country.

 

Mortgage interest rates have risen significantly with no signs of relief, compounded by the rise of remote work and e-commerce, which have led to vacant buildings with no signs of tenants returning. Major cities, like New York, are experiencing severe impacts.

 

“You literally have trillions of dollars of investment that are suddenly just massively impaired,” said Dan Zwirn, CEO of Arena Investors, to the Wall Street Journal. “People thought of these office buildings as forever because, of course, it’s going to be 98% leased forever.”

 

Property Owners Are on Borrowed Time

According to Colliers, a real estate consulting firm, the vacancy rate in U.S. commercial buildings was 17% in the fourth quarter of 2023, higher than during the 2008 financial crash. Lenders, not wanting to end up with foreclosed properties they can’t sell, are delaying legal actions. Tenants who are current on rent payments are keeping buildings afloat temporarily.

 

However, with buildings not fully rented, landlords are facing mounting maintenance issues, and insuring near-insolvent buildings is difficult. Some landlords are deciding to cut their losses, with the New York Times reporting that many commercial properties nationwide are being sold at 50% to 80% discounts.

 

As this trend continues, it’s not only skyscraper landlords who are affected. Businesses and landlords across major cities are struggling as workers relocate, and city budgets face shortfalls due to lower property tax revenues from decreased commercial property values.

 

The Impact of Empty Offices on Cities and Small Residential Landlords

When workers no longer need to live in cities, the entire infrastructure, including smaller landlords, suffers. The pandemic has prompted a significant migration from expensive Northern cities, with many people opting for more affordable living elsewhere.

 

Census data shows New York City was most affected, losing 78,000 residents in 2023. Overall, New York state lost 102,000 people, primarily from the lower and middle classes, earning between $32,000 and $65,000, who no longer needed to endure high rents and cold weather.

 

The Ripple Effect on Banks and Loans for Smaller Investors

Moody’s Analytics reports a national office vacancy rate of 19.6% in the fourth quarter of 2023, the highest since 1979.

 

If landlords foreclose or sell for less than they owe, it could spell trouble for banks with significant commercial real estate debt. The repercussions could impact the lending industry, making it harder for smaller landlords to secure real estate loans.

 

“We saw this play out last year: A bank gets in trouble, and that creates uncertainty in the market,” said Dan Roccato, a finance professor at the University of San Diego, to CBS. “That uncertainty ripples through the stock market, real estate market, and even your 401(k) plan.”

 

Cities may try to compensate for the tax income shortfall from distressed commercial properties by increasing residential property or sales taxes.

 

The Waiting Game Is Getting Tougher

“Survive until ‘25” is a phrase landlords struggling with high interest rates didn’t expect to hear at the start of the year when the Fed hinted at rate cuts. However, with inflation persisting and Fed Chairman Jerome Powell steadfast on maintaining high rates, landlords and investors are growing increasingly anxious.

 

Distressed commercial real estate sales and syndications with floating-rate mortgages show the difficulty of holding on to underwater debt. Banks are also under pressure, carrying debt expected to be repaid. Commercial real estate loans make up a significant portion of U.S. banks’ loan portfolios, and many landlords are extending their loans, hoping for rate cuts.

 

In April, CRED iQ reported that New York landlords SL Green and Vornado had to find $100 million to extend a $1.08 billion loan on 280 Park Avenue. Other owners are opting to redirect their funds elsewhere, reminiscent of the 2008 financial crisis. Patience has its limits.

 

“Last year, borrowers were saying, ‘I just need three months for rate cuts to kick in,’” Alex Killick, managing director at CWCapital Asset Management, told the Wall Street Journal. “We aren’t hearing that anymore. Powell sounded pretty clear that this is the new normal.”

 

Final Thoughts

For investors, letting properties go is a last resort when financial strain becomes unbearable. The Fed’s mixed signals on rate cuts have added to their frustration. While cuts will eventually happen, the timing remains uncertain.

 

Meanwhile, the connections between commercial buildings, lenders, owners, and the real estate infrastructure are fraying, threatening businesses, livelihoods, and cities.

 

Though the pandemic was unforeseen, its aftereffects underscore the need for better preparedness for future crises. At the heart of the issue are interest rates, driving inflation due to the Fed’s previous easy money policy.

 

Other countries have recovered from the pandemic more quickly than the U.S., without experiencing the same inflation and rate hikes. Lessons must be learned.

 

In the meantime, Jerome Powell must offer the nation some hope. Citing economic data is insufficient for landlords on the brink of losing their buildings and residents their homes.


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