Commercial real estate hit hard by Fed's rate hike campaign

Fed's actions lead to a rising number of defaults in multifamily loans

Commercial real estate hit hard by Fed's rate hike campaign

The Fed’s rate hike campaign – including its latest increase of 25 basis points on Wednesday as it fights inflation – has led to a rising number of defaults in multifamily loans and endangers the office and retail sectors as well, a pair of legal experts said.

The latest rate hike represents the 11th increase in 16 months and likely the last one for a while, the central bank signaled. Strongly telegraphed even before the action took place, the benchmark rate hit a range of 5.25% to 5.50% -- the highest level since the Great Recession of 2008-09.

But while the Fed’s actions have had the desired effect on curbing inflation – down to around 3.6% from a 40-year high of 9.1% in June 2022 – the byproduct of the campaign is a rising number of defaults of financial covenants in multifamily loans, according to lawyers exclusively supporting mortgage lenders.

Factors align to create challenges ahead 

Marty Green (pictured left), principal at Dallas-based mortgage law firm Polunsky Beitel Green, sees other sectors negatively impacted by soaring rates besides multifamily. “I think on the commercial real estate side – particularly office space but also retail – will be a little challenging coming in the next year or two, and the rising rate environment is going to exacerbate that,” he told Mortgage Professional America during a telephone interview. “I think the underwriting guidelines are going to be stretched because occupancy on the office side continues to struggle.”

What’s worse, tenant renewals are beginning to come up at a time when many companies have shrunk their operations and scaled back on their office needs. “As leases come up for renewal, a number of companies are downsizing their space needs, so I think you’re going to see an excess of space in that sector,” Green said.

“You’re going to have a couple of things that are coming to a head,” Green said. “One, you have excess space that’s available, so that’s going to be negative as it relates to rental rates. Banks and other financial institutions have tightened their lending standards in light of what happened with the banking sector in March. And then you see the third leg of the stool, if you will, which is the rise of interest rates. Those are going to be impacted very strongly on the commercial side as well, especially because lenders don’t have as much appetite for risk, so they’re going to expect to be compensated for it.”

Buckle up – it’s going to be a bumpy ride

At this point, you may want to forget about that hoped-for economic soft landing, he added: “Inflation continues to moderate and, for now, the economy appears to be poised for a very difficult-to-achieve soft landing,” Green said. “This gives the Fed more runway to continue its inflation fight. However, this soft landing can become very bumpy if the Fed doesn’t recognize that the time is rapidly approaching for it to patiently let the cumulative effect of its decisions work through the economy. 

Justin Barry (pictured right), partner at Morris, Manning & Martin, LLP, said the multifamily sector is being hit hard as the Fed tinkers with interest rates to curb inflation.

“With each round of rate hikes, the Fed puts increasing pressure on multifamily properties with floating-rate loans or maturing fixed-rate loans,” he said. “Many owners are attempting to pass along the increased financial burdens to tenants by increasing rental rates, provided that demand in a particular submarket supports higher rental rates. So, while the Fed is attempting to stave off inflation by raising interest rates, it could actually have the opposite effect on rents.”

He described another endangered front: “The other byproduct of increased rates is a rising number of defaults of financial covenants in multifamily loans – in particular, failure to meet certain debt service coverage ratios or debt yield requirements,” he said. “For the most part, we have seen forbearance from lenders in exercising remedies for these types of defaults; but the million-dollar question remains: How long will lenders ride along before calling these loans?”

The answer may remain rhetorical, as even the Fed conceded the lingering uncertainty – even after ticking off a series of positive economic dynamics: “The US banking system is sound and resilient,” the Board of Governors of the Federal Reserve System said in a statement following their latest interest rate increase. “Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain.”

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