Property’s Waiting Game Is Getting Harder

Last year’s motto in real-estate circles was to “survive until ’25.” Property owners thought the Fed would cut interest rates throughout 2024. If borrowers could just sit tight, it would soon be easier to refinance troubled loans.

Over the past three weeks, borrowers and lenders have both realized this is probably a fantasy. Inflation has been stuck above 3% for three consecutive months. U.S. economic data have remained robust, despite a weaker-than-expected jobs report Friday. 

The one-month forward curve shows that investors now think the secured overnight financing rate, or SOFR, which is closely related to the federal-funds rate, will be 4.825% at the start of 2025. This implies up to two small cuts this year. Back in January, six cuts were expected. 

One immediate consequence is that the cost of hedging has shot up again. Lenders require borrowers of floating-rate debt to hedge their interest-rate exposure, often through interest-rate caps. These instruments pay out when a benchmark such as SOFR rises above a set strike rate, which reassures lenders that borrowers will be able to meet their repayments even if rates rise.

The cost of these caps has become a major headache for property owners, according to Carol Ng, a managing director at risk-management firm Derivative Logic. The price of a one-year extension for an interest-rate cap on a $100 million mortgage at a 3% strike rate is now $2.1 million. Back in January, when the market expected more rate cuts, the same extension cost $1.3 million.

It isn’t just borrowers who are in a tight spot. The longer rates stay high, the greater the weight of unresolved property loans on lenders’ books as commercial real-estate loans get rolled over. According to the Mortgage Bankers Association, $929 billion of outstanding property loans will mature in 2024—a 41% increase on MBA’s earlier estimate. This is because many loans that were due to be paid off in 2023 were extended, adding to this year’s pile of maturities. 

The so-called extend-and-pretend strategy worked well after the global financial crisis because the Fed cut rates from roughly 4% at the start of 2008 to close to zero by the end of the year. Ultralow interest rates turbocharged property valuations in the subsequent years, bailing out bad loans.

But few people expect rock-bottom rates to make a comeback. Stringing things out may be preferable to reporting losses, but it could tie up a lot of capital. Commercial real-estate loans make up more than a fifth of U.S. banks’ overall loan portfolios on average.

The same thing is happening in securitized debt markets, where loans are also being extended rather than repaid. Investors in commercial mortgage-backed securities are becoming frustrated that their money is stuck in notes that may be generating very low returns by today’s standards. A triple-A CMBS bond issued in 2022 can yield as little as 3%.

Higher-for-longer interest rates could also prolong the deep freeze on property deals. Debt costs are so high that it is difficult for buyers to meet lenders’ requirements that the rental income generated by a property cover the debt-service costs by at least 1.25 times. Sellers could capitulate on price to make the math add up, but they are reluctant to take a hit.

This new reality leaves owners of troubled properties with unpleasant choices to make. Before granting extensions on maturing loans, lenders are asking borrowers to show commitment to their buildings by writing fat checks to cut their debts.

Last month, New York landlords SL Green and Vornado coughed up around $100 million to extend a $1.08 billion loan on an office building at 280 Park Avenue, according to CRED iQ analysis. Less deep-pocketed owners may decide their cash would be better spent elsewhere and hand the keys to the lenders. It is becoming harder to persuade landlords to put more money into troubled properties.

According to Alex Killick, a managing director at real-estate services company CWCapital Asset Management, owners have recently started to talk about a plan B: moving early to sell their buildings. This is unappealing as it is still hard to pin down exactly what price a building might fetch. But if they wait, the risk is that a flood of troubled buildings hits the market at the same time, depressing values further.

“Last year, borrowers were saying, ‘I just need three months for rate cuts to kick in’,” says Killick. “We aren’t hearing that anymore. Powell sounded pretty clear that this is the new normal.”

Write to Carol Ryan at carol.ryan@wsj.com