A version of this article appeared in the Dallas Business Journal on July 15, 2024.
From rising interest rates to declining asset values to higher cap rates to slowing tenant demand, the commercial real estate sector faces a growing number of challenges.
The abrupt slowdown in financing is particularly troublesome for US real estate markets as a growing number of loans approach maturity and potential economic recession risks remain.
The risk of default of near-term maturities has risen in recent months creating a debt dilemma in the commercial real estate industry that presents real estate investors with tough decisions.
Learn more about this emerging trend and how it impacts the real estate investing landscape.
Looming Mortgage Maturities
With roughly $4.7 trillion in outstanding commercial real estate loans, according to the Mortgage Bankers Association (MBA), disruption in the market can have wide-ranging implications as prior recessions have shown.
In 2025, an additional $570 billion in loans are scheduled to reach maturity, followed by $460 billion in 2026. In total, approximately $2.0 trillion of commercial real estate mortgages are scheduled to reach maturity from 2024 through the end of 2026. The largest share is multifamily, accounting for approximately 33% of maturing loan volume.
While many of these loans are performing, maturing loans will require refinancing, or, possibly, asset disposition, as borrowers face, yet the largest disruption in borrowing activity since the 2007–2009 recession.
Compounding the issue, the rise in borrowing costs, primarily from higher interest rates and more restrictive covenants, comes at a time when asset values are falling. This combination means that if a borrower can refinance, the investor may be required to contribute additional equity to obtain a loan.
The Rise and Fall of Bank Lending
In recent years, banks, particularly regional banks, increased market share of commercial real estate mortgages. The loosening of capital reserve requirements several years ago allowed many smaller banks to increase lending activity.
By the fourth quarter of 2023:
- Financial institutions held approximately 38% of total outstanding commercial real estate loans
- Agency lenders, including Fannie Mae and Freddie Mac, were the next largest share with 21%, primarily in multifamily loans.
- Life insurance companies held nearly 16% of commercial real estate mortgages,
- CMBS and other asset-backed securities held 13%
- REITs had a 2% market share
Underscoring the real estate debt market’s fragility are recent troubles at banks and financial institutions. Bank failures in 2023 froze an already slowing lending market.
These banks’ distress was caused by several issues and culminated in a run on deposit accounts. Though the outstanding balance of commercial real estate mortgages was large at some of these banks, mortgage performance wasn’t at fault.
According to a Federal Reserve survey, nearly all banks tightened commercial real estate lending standards in recent quarters. Approximately two-thirds of banks reported tighter underwriting during the fourth quarter of 2023 – specifically, 67% of banks tightened standards for non-residential loans, and 65% tightened standards for multifamily loans. This was the first time so many banks reported tightening standards outside a recession.
Lending volume, for both new loans and refinancing, slowed as banks sought to shore up existing loan portfolios and capital reserves. Additionally, several small and regional banks sold real estate loan portfolios, many at a discount to underwritten asset values.
As banks curtailed real estate lending and focused on flexibility for current loans, the capital cycle has been disrupted. Typically, a bank makes a loan over a fixed term and, in the case of a real estate loan with a balloon payment, when the borrower repays the loan at the end of the term, the bank reissues that capital in the form of a new loan to the same or different borrower.
The current flexibility banks offer to real estate borrowers, often at the urging of bank regulators, is vital to preventing foreclosures, but it also curtails banks’ ability to recycle capital. With many loan terms extended to 2024 and beyond, banks aren’t receiving loan maturation proceeds. Bank lending has fallen quickly without this loan repayment cycle.
With nearly $1.8 trillion of commercial real estate loans held, banks are a key source of capital for the real estate sector. Regional and local banks provide a large share of financing for smaller real estate assets as well as in tertiary markets.
Banks are also a major source of construction loans. The inability to recycle capital and the more restrictive lending standards are drivers of the lack of capital available to developers. While limited capital availability hinders development activity, the lack of construction is helping to funnel new leasing demand to existing buildings.
How Distressed Loans Contribute
Even as mortgage distress continues to increase, the share is still relatively small compared to the total amount of outstanding commercial real estate loans. The volume of distressed loans reached approximately $86 billion by the end of 2023, according to MSCI.
The largest share of cumulative distress came from the office sector, which accounted for more than 40% of distressed assets. However, the office sector accounted for a smaller portion of new distress during the final months of 2023, as distress in other sectors accelerated. Only 39% of newly distressed assets were office properties during the fourth quarter of 2023, compared with more than 80% of newly distressed loans during the second and third quarters of the year.
After trending lower for much of the post-GFC period, loan loss rates began to increase at the end of 2022 and through 2023. The peak of asset values in 2022 protected some lenders from greater losses; however, as values continue to decline, loan loss projections will increase. This increase in loss potential makes foreclosures and forced sales less attractive to lenders, potentially increasing interest in repayment flexibility and loan modifications.
Additionally, more than $200 billion of real estate loans were under forbearance plans, had late payments, or were at risk of breaking covenants, such as lease-up rate. This doesn’t include properties with impending vacancy risk, meaning the number of potentially distressed assets is likely greater.
Should lender flexibility end abruptly, a vicious cycle may emerge. Demand fundamentals could deteriorate, helping drive asset values lower which would cause further lender consternation and even tighter lending availability. Without lender flexibility and availability of refinance options, more borrowers will default.
Despite the growing risk level, the volume of distressed assets has remained lower than expected. Lenders have been more amenable to modifying loan terms rather than use special servicing or force asset sales. The flexibility offered by lenders on performing assets has mitigated a substantial increase in borrowers walking away from assets.
Office Sector Spotlight
The office sector is susceptible to a surge in distressed assets. The decline in asset values is more substantial than other property sectors, and demand fundamentals continue to weaken.
The office sector is also undergoing a secular shift, comparable to the evolution of the retail sector in the last 15 years. The combination of maturing loans and impending vacancy risk is particularly acute in the largest cities as well as places such as San Diego, Washington, D.C., and Dallas.
Within the office segment, roughly $210 billion of loans will mature by the end of 2024, though this figure is potentially higher given the large number of loan extensions granted in 2023. More than half of outstanding office loans are floating rate, leading to additional stress on borrowers as rates continue to rise. Though some office loans have extension options, which can mitigate risk, the rising rates may jeopardize viability for floating-rate borrowers, particularly if the property has near-term vacancy risk.
Compounding this issue, many lenders may view office offerings more negatively than other commercial real estate product types. This potentially translates into lower LTVs and stricter covenants, or in more extreme cases, to curtailing new office product loan activity.
Even as rising rates negatively impact floating rate borrowers, a more immediate concern may be the large number of fixed rate loans maturing in 2024. While the Federal Reserve may cut rates modestly in 2024, the cost of capital will be still higher than the maturing mortgage for the vast majority of these loans.
Refinancing terms are much higher than the in-place interest rates, and borrowers will likely need to put in additional equity to offset the declines in asset values.
Example: How Refinancing Terms Impact the Potential Distress
Examining refinancing terms highlights the potential for country-wide distress.
In this example, assume an in-place loan on an office property of $100 million with a 4% interest rate, 80% loan-to-value ratio and debt service coverage ratio of 2.0.
If the loan matures in 2024, and assuming the borrower can obtain new financing in the current environment, conservatively the interest rate could be in the 6% range, a 50% increase in the cost of debt service. The interest rate may be higher depending upon the borrower.
If there’s no vacancy risk, and therefore NOI remains stable, the new debt service coverage ratio would fall to 1.3, highlighting the potential borrowing difficulties fully leased properties may face even without a decline in rental income.
Example: Taking it Further
To take the above example one step further, the value of office assets has fallen substantially. How far asset values have decreased depends on the quality of building, location, rent rolls, and similar factors, but it’s certain that values are lower today than a year ago.
If we assume a decrease in value of 25%, rather than the $125 million value, the property is now valued at $93.75 million for purposes of a loan. It’s unknown if this is a viable sale price.
Not only is this value lower than the principal balance of $100 million on the original mortgage but obtaining refinancing at 80% LTV would net loan proceeds of $75 million, requiring a huge equity commitment by the borrower. More worrisome, estimates for the ultimate loss in value for some real estate assets is much higher.
Based on this calculation, assets reverting to lenders is understandable. However, diminished asset values doesn’t mean all loans will default. For example, a 2015 purchase may have sufficient equity accrued to allow for refinancing without an additional equity injection from the borrower.
Finding Opportunity in Distress
With higher borrowing costs and tighter underwriting standards, the commercial real estate market is facing a potential surge in distressed assets that hasn’t been seen since the great recession. However, key lessons from that period are informing how the current market addresses the potential crisis.
For example:
- Lending flexibility can help borrowers remain current on payments while providing time to re-tenant properties
- Extending or modifying lending terms can help keep assets with borrowers, particularly with office products
- Adjusting maturity dates can help borrowers retain properties
Loan modifications and extensions will enable many borrowers to survive in the near term; however, the combination of declining asset values and the drop in tenant demand will make default the best option for some borrowers.
The rise in distressed assets is unfortunate and reflects negatively on the industry as a whole, however, it creates opportunities for other investors.
A large amount of equity capital remains on the sidelines awaiting stabilization of falling asset values. Nearly $400 billion of dry powder capital is available, according to Preqin. Much of this capital has yet to deploy given the spread between buyer and seller expectations. Once asset pricing reaches a sufficient discount or values appear to stabilize, opportunistic equity capital may flow into the market at a greater pace.
As with any investment, a bargain price does not guarantee returns and investors should carefully examine real estate opportunities.
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