When Moody’s pulled the trigger on downgrading the U.S. credit rating from Aaa to Aa1 earlier this month, the U.S. officially lost its AAA status from all three major credit agencies.
Let that sink in.
S&P led the charge back in 2011. Fitch followed in 2023. And now Moody’s has completed the trifecta. The primary driver? Concerns around ballooning government debt and the government’s ongoing inability to tackle fiscal discipline.
I actually dove into this topic in a prior piece where I broke down the national debt and ran a high-level analysis of the U.S. credit profile. [You can find the link to the post HERE.]
But today, let’s focus on what this downgrade actually means for real estate – and why it matters now more than ever.
The Credit Hit: A Shift in Risk and Return
Downgrades like this do not just hurt pride – they shake the very foundation of how risk is priced.
- U.S. Treasuries now carry a higher perceived risk, which means investors will demand higher yields.
- Large institutions like pension funds and hedge funds or foreign governments holding US debt, many of which have strict credit quality requirements, may be forced to reshuffle their portfolios. This can lead to massive selloffs, driving bond prices down and pushing yields even higher.
- Treasuries serve as the baseline for pricing everything from mortgages to commercial loans. As yields climb, so does the cost of debt.
- And since interest rates are a key factor impacting cap rates, real estate operators and investors can expect persistently elevated cap rates (barring a supply shock, which we are not quite seeing yet based on today’s data).
Bottom line: the cost of capital is going up, and it is not just a blip.
The Capital Crunch: Why Equity Is More Valuable Than Ever
With debt becoming more expensive, and lenders continuing to size loans around debt service coverage, equity is stepping into the spotlight.
- Leverage is likely to remain moderate at best (higher cost of debt will likely mean LTVs remain low to moderate in order to maintain the minimum DSCRs required by the lender).
- Equity – particularly from reliable, experienced fund managers and capital partners – will be in high demand to fill the financing gap.
- Deals will need to be structured with precision, ensuring capitalization is solid from day one.
This environment favors those who are well-prepared, well-connected, and well-capitalized.
Mitigating the Risk: Practical Moves in a New Reality
It is not all doom and gloom but it is time for discipline.
Here is what I am advising across deals I am reviewing right now:
- Underwrite with conservatism. Aggressive exit cap assumptions are dangerous in this environment.
- Hedge interest rate exposure where possible.
- Focus on deals with positive leverage and strong in-place cash flow.
- Make sure the sponsor has equity locked – ideally with a proven track record of raising it prior to or shortly after close.
Final Thoughts
This downgrade marks more than just a headline – it is a signal that the fundamentals are shifting. The ripple effects are already hitting real estate, and how we respond now will define performance over the next cycle.
Vessi Kapoulian
Protect the downside. Grow your wealth.
Download The Busy Professional’s Quick Guide To Investing In Multifamily here.
Disclaimer: The information presented does not constitute legal, accounting, tax, or individually tailored investment advice. Past results do not represent or guarantee future performance.