The risks of floating rate debt

Distressed real estate portfolios put disclosure, coverage risks in focus

KEY TAKEAWAYS

A wave of commercial real estate debt maturities is adding to pressure on portfolios that used floating-rate debt to buy real estate when interest rates were lower.

Distress is showing up in certain pockets of real estate, particularly multifamily in markets where rents softened due to oversupply.

Insurance buyers may use this opportunity to reassess program structures and strengthen documentation of investment decisions.

In 2026, nearly $875 billion worth of commercial real estate loans will mature.

That’s according to the Mortgage Bankers Association, which points out that 2026’s total amounts to 17% of the $5 trillion in outstanding commercial real estate debt held by lenders and investors.

The prospect of refinancing becomes more challenging in a higher interest rate environment and may expose weaker capital structures.

This is particularly the case for commercial real estate owners who built significant portions of their portfolio on floating-rate debt when interest rates were low and income streams from their holdings were strong and dependable.

“For many real estate owners, the challenge is not simply that interest rates are higher," said Aaron Culbertson, Senior Vice President and U.S. Real Estate Practice Leader for Lockton. "The real issue is that portfolios acquired or recapitalized in a low-rate environment were often underwritten on assumptions that no longer hold true: cheap debt, cap rate compression, strong rent growth, and abundant liquidity. As rates rise and stay elevated, weaknesses in capital structure can become exposed."

Portfolios acquired or recapitalized in a low-rate environment were often underwritten on assumptions that no longer hold true: cheap debt, cap rate compression, strong rent growth, and abundant liquidity.

Aaron Culbertson U.S. Real Estate Practice Leader, Lockton

Conversations with lenders and investors may be fraught, potentially leading insurance buyers to rethink their coverage design, disclosure discipline, and executive risk.

Distressed real estate portfolios, particularly office and multifamily properties in certain markets, are starting to surface.

Real estate buyers with comparatively less capital who scooped up properties in 2021 and 2022 with variable-rate debt counted on interest rates staying low.

That didn’t happen, as the Federal Reserve increased interest rates by 500 basis points in 16 months to counteract skyrocketing inflation in 2022, the fastest increase of the federal funds rate since 1982. For certain buyers, a perfect storm followed:

Higher interest rates drove up debt service costs, eating into net operating income.
In oversupplied markets, such as multifamily housing in the Sun Belt and the Southwest, rents began to fall between 2023 and 2025, also cutting into net operating income.
Portfolios with higher debt service costs and lower rent income have difficulty attracting new investor capital.
Other expenses have increased, such as property taxes — particularly in states with no income tax — utilities, and insurance costs.

Given Fed Chairman Kevin Warsh’s unexpectedly hawkish comments at the central bank’s Jackson Hole Economic Symposium, distressed real estate owners should not expect a monetary policy bailout.

Insurance considerations

Traditional lenders, such as banks, are open to refinancing debt if the underlying asset has strong fundamentals. Underperforming assets will find a limited audience for refinancing, if they can find one at all.

Multifamily owners with longer-ended funds, less reliance on outside capital, and stable financial structures have more flexibility than those that are thinly capitalized and barely meet loan-to-value thresholds.

Owners with a mix of asset types may find that their overall insurance structure benefits from segmenting different portions of their portfolio into separate programs.

For example, a carrier may look at an overall portfolio of commercial assets, half of which is multifamily, and decide the risks require higher rates, retentions, and exclusions.

Another consideration for real estate owners whose portfolios face distress is to document their decision-making meticulously.

Owners of distressed real estate portfolios will face scrutiny from investors who are dissatisfied with their returns.

This can lead to private (or public, in the case of publicly traded companies or listed REITs) directors and officers (D&O) claims if investors come to believe they were not given the full picture of how their investment was performing.

Owners who can document their investment decisions, including reasons they may have deviated from their normal decision-making or processes, can build a defensible position for their thinking.