Here's why the Fed cutting interest rates is a double-edged sword for commercial real estate

A pedestrian walks by a commercial property for lease in San Francisco, California.

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• Commercial real estate is widely seen as the next shoe to drop after the collapse of Silicon Valley Bank.
• A wave of CRE debt is coming due and will need to be refinanced at higher interest rates at a time when occupancy rates are low.
• Interest rate cuts from the Fed would provide some relief to the CRE space, but not if they come alongside a recession, according to Bank of America.

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Commercial real estate is viewed by some investors as the "next shoe to drop" after the collapse of Silicon Valley Bank last month, and potential interest rate cuts from the Federal Reserve may not be enough to prevent that shoe from dropping.

A recent note from Bank of America says that's because interest rate cuts from the Federal Reserve are a double-edged sword in that while lower interest rates will help companies service their debt, it won't do much good if the rate cuts are accompanied by an economic recession.

Commercial real estate has been in a world of pain ever since the COVID-19 pandemic started. The industry has been suffering from low occupancy rates as many employers opt for a work-from-home or hybrid work environment. That's led to falling rent prices thanks to an over supply of empty office floors in cities across the country.

Dwindling rents, combined with nearly $450 billion of commercial real estate debt set to be refinanced at higher interest rates over the next year, means the Fed really can continue to break areas of the market with its aggressive interest rate hikes.

But could interest rate cuts from the Fed — which the market expects will happen in the second half of this year — help alleviate ongoing concerns in the commercial real estate market?

Yes and no, according to BofA.

"While lower interest rates would undoubtedly bring relief to CRE borrowers (potentially mitigate credit events for the banks), the asset class is not immune to cyclical challenges, especially if the US economy experiences a hard landing," analyst Ebrahim Poonawala said in a Thursday note.

Any deterioration in the job market can compound the weakness seen in commercial real estate, and growing interest in converting empty office buildings into residential apartments is not a viable short-term solution to the problem. 

And according to BofA's Alan Todd, while lower interest rates would help a lot of commercial real estate debt be refinanced at more accommodative interest rate levels, it may not be that big of a relief due to the mounting concerns plaguing the sector.

"The cost of lending charged is unlikely to decrease materially as credit concerns proliferate since lower interest rates would also likely suggest a weaker overall economy," Todd said.

"At the margin, lower rates would be helpful for some borrowers, but lower CRE prices and tighter lending standards more generally would blunt some of the potential upside for weaker borrowers that lower interest rates might otherwise have delivered," Todd said.

What's clear is that there's no easy fix for the ongoing issues surrounding the commercial real estate market, and even potential rate cuts from the Fed may not be enough to prevent a wave of defaults in the sector. Instead, a wait and see approach is most likely, according to the note.

"We think many lenders will opt to 'kick the can' until market sentiment improves and fundamentals firm with the hope that liquidation proceeds will be higher than they would be if they sold the property in today's market environment," Todd said. 

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