Climbing interest rates have now pushed the commercial real estate market to a watershed moment: negative leverage. The cost of debt to finance real estate deals is now exceeding the expected returns on those investments, which will ultimately drive bid prices higher, or worse, dissuade investors from keeping their properties.
A new report by Moody’s Analytics showed that in 2022’s third quarter, over $5.5 billion (28 percent) of new commercial mortgage-backed securities had negative leverage, meaning that the cost of debt exceeded asset revenue. That’s a huge leap compared to the third quarter of 2021, where only 2 percent of similar loans had negative leverage. As of now, the multifamily and industrial sectors are more likely to contend with negative leverage as renters are beginning to face affordability ceilings and warehouse demand has fallen since last year’s industrial push.
Though these rates of negative leverage haven’t been seen since right before the financial crisis of 2008, negative leverage is usually an indicator that the commercial real estate market has entered a transitory phase. Now that interest rates have eclipsed acceptable yields for buyers, lending volume will most likely drop (at least in the short-term) as deals that were on the table get postponed until the Federal Reserve can finally get a wrangle on inflation.