CMBS bankers and borrowers are eagerly awaiting lower interest rates as a path to cheaper financing, hoping that this can increase the value of commercial real estate and increase issuance volume.
Although market participants are rightly pleased with lower interest rates, it will take more than a few rate cuts to have a noticeable impact on borrowers.
After the Fed has cautiously tried to find the right time to lower interest rates, the fact that a rate cut is imminent is already taken for granted.
CMBS market participants are enthusiastic. They sense that the worst is almost over for CMBS. They have felt the Fed’s mantra of trying to drive out inflation by keeping interest rates “higher for longer” more than most other asset classes.
But some of this enthusiasm is misplaced. In reality, significantly lower borrowing costs are still a long way off.
It is certainly encouraging that borrowers will soon be able to obtain better financing terms to finance acquisitions or refinance debt. But it will take more than one or two meager 25 basis point rate cuts to achieve tangible benefits.
On the margin, some deals might benefit immediately because it suddenly makes sense to do them with better capitalization and debt coverage ratios. But we are talking about marginal deals here and there – not a significant amount of issuance that will significantly change the volume.
Unfortunately, for many CMBS borrowers, the rates make so little sense that they will need several more cuts. For example, an S&P CMBS report released in early July said that out of 50 SASB offerings rated in the first half of 2024, the agency had rejected 18 ratings – primarily because they could not cover debt service on day one based on projected cash flows and Sofr levels.
Such a deal needs much more than a 25 basis point cut to end the suffering. Most loans require a major policy shift, not just a few nudges in that direction, to make refinancing truly attractive. Deals are now being funded at a Sofr of about 5.3%, down from 0.5% in 2021-2022.
Even a handful of interest rate cuts are likely to keep the Sofr at a historic high.
As a May S&P report shows, there is little room for error in the many SASB deals with debt service ratios close to 1.0. These deals have little ability to weather cash flow disruptions, even when taking into account the benefits of lower interest rates on floating rate financing.
So, be sure to have courage. But also be aware that we are still in the early stages of recovery.
The excitement in the CMBS market is likely due to the fact that we are ultimately heading into a period of significantly lower interest rates – not that a few 25 basis point declines this year will revive market activity overnight.
While there may not be much excitement about the transmission of interest rates into economic activity in 2024, 2025 will be the year when things will change.
