First comes the easy money, then comes the defaults, especially when property owners have paid out all their money.
Investors are bracing for a pretty bleak 2024 in the US commercial real estate market, with more landlords expected to throw in the towel on downtrodden buildings with mounting debt.
Higher interest rates and fluctuating property values remain a source of fear, even as interest rates have fallen sharply since the collapse. A crucial signal to watch is how much equity borrowers have left in the buildings they own.
For years, commercial real estate owners pocketed billions of dollars by refinancing properties at sky-high values while debt was dirt cheap. As valuations decline, the debt associated with these properties is increasingly greater than what the buildings are worth. The owners are not expected to now throw the money they took off the table into a sink.
“I think if you have someone significantly underwater, he or she might just want to give the keys back,” said Gabe Rivera, co-head of securitized products at PGIM Fixed Income, a division of PGIM, Prudential’s asset management business with a worth $1.2 trillion. Financial Inc. PRU,
“Nobody throws good money after bad.”
Rising default risks
Regulators said in December that the pile of nearly $6 trillion in outstanding commercial real estate loans, about half of which was held by banks, posed a biggest threat to the financial system by 2024.
Delinquencies and loan defaults, while still well below past peaks, have increased in recent months as more borrowers struggle to adjust, pay off or refinance maturing debt.
The nation’s largest landlords have regularly turned to Wall Street’s commercial mortgage-backed securities market over the past decade for loans of as much as $1 billion, or to finance real estate portfolios, often on a non-recourse basis.
““I think people who are significantly underwater might just want to give the keys back.” ”
Blackstone Inc. BX,
Brookfield Properties BN,
and Columbia Property Trust, which is controlled by Pimco funds, made headlines in 2023 as part of an early wave of defaults, or write-downs, in this cycle.
CMBS loans are popular because they typically protect an owner’s personal assets and other property in the event of default, making it easier to walk away. During market upturns, these loans often include borrower “cashouts.”
When borrowers cash out, the funds are often treated as equity by property owners. It can be used to finance building upgrades or purchase other assets, with few liabilities.
“It’s definitely a topic that’s very relevant,” said Greg Handler, head of mortgage and consumer lending at Western Asset Management Company, a fixed-income manager with $369.5 billion in assets under management.
“If they have already paid out money,” Handler said, this reduces the likelihood that a borrower will stay with a property or invest equity to refinance maturing debt.
Blackstone said in a statement to MarketWatch that it aims to invest in sectors with strong fundamentals that benefit from trends in macroeconomic demand. “That’s why the majority of the real estate we own is in sectors such as logistics, student housing and data centers and why less than 2% of our owned portfolio is traditional US offices.”
Pimco and Brookfield did not immediately respond.
‘The money was there’
Payouts increased rapidly in the run-up to the 2007-2008 global financial crisis, and again as credit markets revived in the era of cheap debt that followed.
“When you had the payouts, interest rates were so low and every bank and non-bank lender was willing to make loans,” said Justin Newman, partner at law firm Thompson Coburn. “Everyone paid out because the money was there and you can’t refuse it.”
Specifically, over the past two decades, borrowers have pulled about $141.5 billion in cash from U.S. commercial real estate financed by Wall Street’s CMBS market, while withdrawing about $50 billion, according to a DBRS Morningstar tally compiled for MarketWatch.
That translates to about $93.5 billion in net cash, most of which was withdrawn during the past decade of low interest rates, the data show.
The CMBS market, which has only been a 6% to 25% slice of the lending pie in recent years, serves as a barometer for trends in the broader commercial real estate industry.
Unlike banks and other lenders that typically hold loans on their books, the CMBS market packages its mortgages into bond transactions that are sold to investors, spreading risk across state lines and throughout the financial system.
On the other hand, the market also offers loan-level financing details that other lenders do not often disclose. Bond investors also receive monthly performance updates at the property level, which can show the first signs of stress.
Emergency ahead
Pressure on commercial real estate began to mount in 2023, as an initial wave of real estate lending matured during the Federal Reserve’s rate hike cycle, and the financial cores of many major cities saw only a halting return of workers to offices after the pandemic.
The Fed may now be done raising rates and more companies need more days in the office, but borrowing costs are still expected to remain well above pandemic lows, keeping real estate values under pressure, market participants said .
Interest rates, which were set at 6.5% in late December for commercial real estate loans, have fallen back from above 7% this fall but remain well above the pandemic low of less than 4%. The yield on the 10-year U.S. Treasury bond BX:TMUBMUSD10Y recently fell to 3.87%, but remains much higher than the 1.4% of two years ago.
That doesn’t bode well as an estimate $1.According to data from the Mortgage Bankers Association, 2 trillion in commercial mortgage debt will mature by 2025.
Moody’s Investors Service said in December that roughly a fifth of the $42.3 billion in CMBS loans maturing next year could have increased default risk, with office loans of particular concern.
Some maturing loans will be rolled over by lenders, while other borrowers could find relief from the estimated $135.5 billion in “dry powder” that private equity firms collected globally in December for real estate opportunities, Preqin data shows.
“My view is that this will be a slow bleed, a situation where keys go back to lenders, regional banks sell assets and pension plans disappear,” said Seth Meyer, head of fixed income strategy and portfolio manager. at Janus Henderson Investors, which has $308.3 billion in assets under management.
“This will create opportunities,” Meyer said. “This is where it’s going to be a credit picker’s market for a while.”