It comes as no shock, particularly for those who follow my newsletters or tune into my macroeconomic reviews on YouTube, that we are potentially on the cusp of an unprecedented downturn in the commercial real estate sector. This is a topic we have meticulously examined over the past year both in my news publications and on my YouTube channel, The Blind Economist.
In this dialogue, I’d like to delve into some underpinnings of this anticipated market decline.
–Insights from Wall Street
–Assessing the Commercial Property Crisis through Mortgage Bonds
–Commercial mortgage-backed securities (CMBS) may reveal distressing signs about bank-held loan portfolios.
We’re observing just the beginning stages of turmoil in the U.S. commercial office loan sector, with possible indications coming from a specific lending market segment. Banks, which are responsible for issuing nearly half of all commercial real estate loans in the U.S., often lack transparency concerning the status of these loans or the properties they’re tied to until facing adverse consequences. The first warning sign for investors may emerge as large financial provisions set aside for anticipated losses, which was the case with New York Community Bancorp and Japan’s Aozora Bank, leading to plummeting of their share values by 53% and 34% accordingly after announcing deteriorating U.S. office loans.
There exists a method to indirectly gauge the intensifying strain on bank loan portfolios. CMBS, which forms about 14% of U.S. commercial real-estate lending, serves as an informative indicator. Fortuitously, the CMBS sector releases monthly insights into default rates and current property valuations, offering crucial data for analysis.
Concerns were high regarding the fate of last year’s matured office CMBS debt. CRED iQ, a provider of real estate data, reports a mere 26% of the $35.8 billion in office CMBS loans due in 2023 was fully repaid. This reflects the challenges borrowers faced with refinancing or property sales.
A portion of the maturing mortgages was prolonged, while a significant number, amounting to more than 1,000 loans valued at $14.8 billion, moved to special servicing. Such servicers aim to negotiate the best resolution for the debt, which may include restructuring the loan terms or even property foreclosure.
The distress within the CMBS office loan segment is evident, as 10.5% is in distress as of the January endpoint—this figure has more than tripled compared to the previous year. The definition of ‘distressed loans’ encompasses those overdue by over 30 days or those under special servicer management. With a looming $46.6 billion of such loans due by 2025, these numbers hint at potential escalation.
One particular area of concern lies in the devaluation of office properties within the CMBS framework. Updated appraisals are mandated when loans shift to special servicing, leading to an alarming discovery: offices in the reevaluation have seen average value declines of 40%, with some 2023 revalued properties plummeting close to 50%.
However, the comparison may be less dire when considering loans held by banks. Typically adopting more conservative loan-to-value ratios, banks have more flexibility in negotiating with borrowers, given their private channels for negotiation. Additionally, the non-recourse nature of CMBS loans affords landlords the option to surrender properties should the debt surpass the building’s worth. Conversely, bank borrowers risk more if they have furnished personal guarantees against loans.
Bank shareholders are facing the potential for unexpected financial setbacks due to loan maturities, and the situation is exacerbated by the growing frequency of office buildings being sold at significant discounts. This trend challenges banks to reassess their “pretend and extend” strategies, as fresh data from office property sales necessitates a reevaluation of loan values.
The task of forecasting where the next financial crisis may arise is complex. Rich Hill, Senior Vice President at Cohen & Steers, points out that although billions in office loans sit on bank balance sheets, both domestically and internationally, the precise details of who holds which loans for individual properties remain inadequately disclosed. “We recognize there is an issue, but quantifying the extent of it among different lending institutions is difficult,” Hill explains.
An on-the-ground look at any major urban business district in the United States reveals a noticeable decline in occupancy and value of office buildings compared to their status four years prior. The impact of this downturn is evident as the S&P 500 Office REITs Sub-Industry Index has seen its value cut in half since the onset of the pandemic, signaling a period of reckoning for banks that is only just beginning.
Current data crafted from the commercial mortgage-backed securities (CMBS) market paints a bleak picture regarding office valuations. When special servicers acquire loans, they reassess the properties to estimate their fair market value. Based on recent reappraisal data of 220 at-risk loans, there’s an average devaluation of 40% for office spaces. For buildings reappraised in 2023, the value reduction has been a staggering 50%.
However, it may be that the condition of loans held by banks is not as dire as the CMBS data suggests. In general, banks tend to maintain a more prudent approach with their loan-to-value ratios, and they possess the flexibility to discreetly negotiate with borrowers. Furthermore, the non-recourse nature of CMBS loans gives property owners the option to simply return the keys should the debt exceed the building’s worth— a choice not as readily available to bank borrowers, who often provide personal guarantees for their loans.
As the CEO of Macroeconomic Solutions, affectionately known by our followers as The Blind Economist on YouTube, I am committed to delving deep into the economic currents shaping our world. Understanding the “what” is happening is merely scratching the surface – my focus is on unraveling the “why,” which is the true undercurrent of our economic narrative.
True wisdom, as I define it, is the mastery of applying knowledge effectively – having knowledge alone simply won’t suffice. I wholeheartedly encourage you to connect with me; your insights on these economic complexities are invaluable. Please don’t hesitate to send your thoughts to my email at michael@theblindeconomist.com.
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Signing off, I am Michael Anthony Francis, your chief executive officer at Macroeconomic Solutions – your partner in venture capital and strategic consulting. Looking forward to our next exchange, until then, I’ll see you on the flipside.
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