The rise in US government bond yields, accompanied by an increase in the Federal Funds Rate and an oil price of $105 per barrel, is leading to a more cautious stance among lenders and investors. On 23 September, the yields on 10-year and 30-year government bonds reached their highest levels in 19 years, with the 10-year bond reaching 5.1 per cent and the 30-year bond reaching 5.4 per cent. These values were last recorded shortly before the onset of the global financial crisis in July 2007.
The announcement of these high yields, combined with the memory of the turbulence nearly two decades ago, sent immediate shockwaves through the commercial real estate sector. The experiences of the GFC are still fresh in the minds of many capital market participants. A week prior, on 16 September, the new Federal Reserve Chairman Kevin Warsh had also announced an increase in the Federal Funds Rate by a quarter percentage point to between 3.75 per cent and 4 per cent, a decision unanimously taken by the Federal Reserve Board of Governors.
Persistently high interest rates shape the market
For the commercial real estate market, the latest interest rate development points to a challenging reality: the 'higher for longer' scenario now appears permanent, with no expectation of relief. Jonathan Roth, co-founder of 3650 Capital, noted that the situation has become more difficult for borrowers, owners, and operators alike, as everyone had hoped for a relaxation of interest rates. While the Federal Funds Rate influences the short-term interbank interest rate, which correlates closely with floating debt and construction financing, the 10-year government bond yield determines the cost of credit for the most significant areas of the American economy, including government bonds, mortgages, credit card and car loans, corporate loans, and many commercial real estate loans.
If Treasury yields rise to 5 per cent, this also leads to higher cap rates (capitalisation rates), which represent the potential return for investors on real estate. Higher cap rates result in falling property values in commercial real estate and vice versa. This development affects not only existing properties requiring refinancing but also new development projects, value-add deals, and special rescue capital, all of which must now account for higher prices and lower returns. Brad Case, chief economist for residential real estate at Homes.com, explained that it has become very difficult to calculate new developments, value-add situations, or regular acquisitions, meaning that new construction projects are becoming increasingly challenging.
Erosion of confidence and market adjustments
The seemingly permanent phase of high interest rates follows nearly five years during which rates rose sharply – the 10-year bond increased from 1.3 per cent in November 2021 to 4.1 per cent in November 2022. Previously prevalent optimistic assumptions, such as 'Stay alive ‘til ‘25' and 'It’ll be fixed in ‘26', have receded into the background. Jon McAvoy, Chief Investment Officer at PRP Real Assets, observed that many overcapitalised owners, or those on the verge of default, were rescued by bridge lenders or CMBS, but this is now largely over. The conviction that extensions are possible and the market will recover has largely eroded.
- —After-effects of high tariffs and associated uncertainties.
- —Annual multi-trillion dollar federal budget deficits.
- —The war with Iran and the closure of the Strait of Hormuz.
- —A resulting increase in global oil prices.
The reasons for this erosion of financial confidence are manifold and include the after-effects of high tariffs with their uncertainties, annual multi-trillion dollar federal budget deficits, a war with Iran ongoing for over six months, as well as the closure of the Strait of Hormuz and a subsequent drastic increase in global oil prices. Ryan Severino, Chief Economist and Head of Research at BGO, described the situation as symptomatic of the current environment: the world is processing the realisation that this is no longer the CRE environment of the previous generation, and 5 per cent yields seem frightening.
Other observers note that many deals are failing completely. Scott Rechler, Chairman and CEO of RXR, reported many failed transactions where buyers and sellers agreed on specific prices but then withdrew, stating they were no longer proceeding at that price, especially in the multi-family sector. As many transactions financed during the extremely low post-COVID interest rates of 2021 and 2022 were structured with five-to-seven-year terms, the prospect of persistently higher interest rates could trigger a cascade of sales that were avoided over the past two to three years due to optimistic economic forecasts. Joe Biasi, Managing Director and Head of Commercial Capital Markets Research at Newmark, explained that the difference lies in the fact that the market had anticipated falling interest rates in 2024 and 2025. If this expectation no longer holds and many loans are extended, transaction volumes could shift towards distressed sales.
