February 26, 2025 - Interest rates drive the cost of capital. As of the past few weeks, post-inauguration, interest rates are now largely dependent on international policy.

President Trump has promised tariffs on some of the U.S.’ largest trading partners such as China, Canada, and Mexico. According to Dr. Anirban Basu, an economist and Chairman of the Sage Policy Group, Inc., such tariffs would likely dissuade the Federal Reserve from lowering interest rates. This would, in turn, substantially affect the cost of capital in a pivotal year for commercial real estate.

Let’s explore the interrelated factors that could affect the cost of capital, including:

• Prospect of tariffs
• Looming commercial loan cliff
• Rise of private credit
• Shifting capital stack
• Easing commercial oversupply
• Global instability

Prospect of Tariffs

Prior to the presidential election, there was a consensus among banks and forecasters that the Federal Reserve would likely drop rates three times in 2025, from the current 4.33%. The Fed wants to maintain an inflation rate of about 2% for long-term economic health, and dropping interest rates now (in a period of lower inflation) would give the economy a chance to return to this optimal level.

Currently, the administration’s proposed 10% tariff on all imports may disrupt the Fed’s cuts. It is worth noting that modern tariffs tend not to be an effective way to increase GDP because trading partners can pick new suppliers and impose retaliatory tariffs. Studies show U.S. consumers tend to bear the costs. The Federal Reserve’s chief worry about tariffs would be that they increase consumer costs and, thus, inflation.

Higher inflation would be a reason to defer their rate cuts.

As Christopher Waller, a member of the Fed’s board of governors, told the Associated Press: “I believe more cuts will be appropriate. If, as I expect, tariffs do not have a significant or persistent effect on inflation, they are unlikely to affect my view.”

Even at the very top, everyone is planning for different scenarios. We recommend you do the same.

Looming Commercial Loan Cliff

If tariffs occur and the Fed does not lower interest rates, borrowing costs will remain high, affecting the looming loan maturity cliff. According to the National Association of Realtors, some $1.8 trillion of commercial loans are maturing before 2026. To date, there has not been more panic around this event because lenders and borrowers have an unspoken agreement that they will work something out. Borrowers will likely ask for extensions, interest-only payments, or other workarounds.

Many of these agreements and calculations were formulated when everyone expected the cost of borrowing to fall. Now, any real estate business looking to refinance will have to negotiate a higher cost of capital. This would be particularly painful for those whose mortgages were negotiated during a period of very low interest rates.

Rise of Private Credit

Another reason there has not been more panic around the maturing debt load is that borrowers have struck new gold in the private credit markets. Private credit, or credit from non-bank lenders such as private equity, alternative asset managers, and family offices, expanded rapidly from $1 trillion to $1.5 trillion between 2020 and 2024. Morgan Stanley predicts it will soar to $2.6 trillion by 2029.

There is a chance that if the banking industry cannot absorb all the reworked debt details, the private market may. On the surface, it may sound acceptable. However, private credit often means a higher cost of capital.

Shifting Capital Stack

As we discussed in our most recent real estate opportunity report, investors favor the sandwiched center of the capital stack. They increasingly prefer mezzanine debt to distribute their risk and not be entirely out on the equity side. So far, all the economic turbulence of the 2020s has made projections less reliable.

One major advantage of preferred equity and mezzanine debt is the flexibility they can offer investors in the present mercurial market. While the interest rates may seem high at first glance, they are often lower when viewed as part of the overall weighted cost of capital.

Easing Commercial Oversupply

While the office market remains unimproved, some sectors look promising. Multifamily oversupply seems to have tapered off as demand has outpaced construction. Meanwhile, office-to-residential conversions are unlikely to affect the supply equation — though they frequent the news, currently slated projects account for just 1.7% of all commercial square footage.

Several other commercial real estate sectors also look promising. Manufacturing and industrial looks strong, and retail is entering this year with the lowest vacancy rate of any commercial real estate sector, according to CBRE.

Easing oversupply, higher rents, and improving economics could mean a lower cost of capital if it brings more institutional investors back into commercial real estate.

Global Economic Instability

Worldwide, more than half of chief economists — 56% — predict a downturn, according to the World Economic Forum. Just 17% expect to see improvement.

Predictions are not prescriptions, of course. Chief economists are as often wrong. The U.S. economy beat predictions in 2024, growing 2.4%, and there is a broad consensus that despite any pains, the U.S. will grow even more this year. Whether international instability affects domestic real estate remains to be seen.

Opportunities Will Arise No Matter the Market

Harvard Economist and author of The End of Average Todd Rose coined the so-called “Jaggedness principle,” reminding us that there are usually anomalies in the details of any data set.

While a market may be down, particular properties or neighborhoods may be up and outperforming the odds. Or a particular sector may outperform the rest. We expect real estate firms to find many such opportunities this year.

Even if the cost of capital should rise, it will not rise evenly for all classes. Be on the lookout for these opportunities and build the financial toolset and capital stack to take advantage of them.

To discuss capital stacks, private credit, and the cost of capital with our team, which specializes in these topics, please contact our Real Estate Industry Practice.