Property Market Hits Inflection Point as Debt Cost Outpaces Rent

The cost of debt on commercial property has risen so fast that it’s now more expensive to finance many real estate deals than owners currently earn from rents.

About $5.5 billion, or 28%, of new commercial mortgage-backed securities had negative leverage — where the cost of debt exceeded projected returns on investments — in the third quarter, according to a report by Moody’s Analytics. Only 8% of similar loans had negative leverage in the second quarter and barely 2% were negative in the third quarter of 2021.

Properties such as warehouses and apartments are more likely to face these issues, given prices had soared as investors bet they could generate positive returns by raising rents. Now, warehouse demand is cooling and apartment landlords are pressured as renters start to reach affordability limits.

“Ultimately, negative leverage will drive bid prices lower,” Kevin Fagan, head of commercial real estate economic analysis for Moody’s, said in an interview. “You’re either not going to buy that investment, or if it comes to refinancing, you might have to hand the keys back. You might not be incentivized to save the property.”

The CMBS deals capture a limited slice — but are a representative bellwether — of all commercial real estate financing, Fagan said. The Federal Reserve has aggressively raised interest rates to combat inflation, a move that has driven up the cost of debt in areas such as real estate. Borrowing costs in CMBS deals for warehouse and industrial properties have jumped to 5.29% from a recent low of 3% in the last quarter of 2021, Moody’s reported.