Conditions are ripe for a spike in commercial mortgage delinquencies. Rising interest rates have pushed loan coupons significantly higher, lenders are cutting back to varying degrees and property fundamentals are weakening amid slowing economic growth and consensus recession forecasts.
Considering current circumstances, an uptick in defaults is a near certainty, but the exact amount is yet to be determined. The extent of the issue will depend on various factors analyzed in this study.
- Wall of maturities: Loans on 15.6% of office properties and 13.5% of industrial properties will reach maturity between 2023 and 2025
- Maturing loans by market: A look at potential hotspots for distress based on the number of maturing loans and the vacancy rates of individual metros
- Factors determining distress: How much distress will the drop in property values and tightening loan underwriting create
- Is there systemic risk again? How similar are current circumstances to the last down cycle in 2008-2010
The Potential Wave of Distress
Loans coming due face a higher interest-rate environment than when they were originated, while lenders are underwriting at more conservative debt-service levels. Some properties will qualify for less proceeds than the existing debt, 20-30% in some cases, creating a capital gap that borrowers must fill through an injection of equity, mezzanine debt or preferred equity; negotiating an extension; or handing the keys to the lenders.
The market is bracing itself for a wave of distress. Private equity is raising funds for opportunistic investments, such as “rescue” or “gap” capital, to take advantage of the opportunity to capitalize on performing assets that can’t refinance. Evidence of rising defaults is starting to show up in CMBS delinquency-rate data and news reports of property owners (including some well-capitalized firms) turning in the keys. The potential problem is substantial, given that there are $4.5 trillion of commercial mortgages, according to the Mortgage Bankers Association, with more than $1 trillion maturing between now and the end of 2025.
Office Loan Maturities by Metro/Vacancy Rate, 2023-2025
Given the circumstances, an increase in defaults seems certain, but how much is an open question. The extent of the problem will ultimately be determined by a variety of factors that include the property type; the fundamentals of the markets in which loans are maturing; the length of seasoning, coupon rate and performance of the individual properties with loans coming due; and the future interest-rate environment.
Maturing Loans by Market
To get a handle on the size of the maturity issue and the potential for default, we tabulated from the CommercialEdge property databases the number of maturing office and industrial loans. The analysis found that loans on 15.6% of office properties encompassing 1.1 billion square feet and 13.5% of industrial properties with 1.5 billion square feet will mature between 2023 and 2025.
To identify potential hotspots for distress, we plotted the number of maturing loans against the vacancy rates of the individual metros. Areas where property performance is poor naturally pose a higher probability of default than markets where demand and income are strong.
Markets with the highest percentage of office loans maturing between now and 2025 are Atlanta (19.7%), Orange County (21.8%), Denver (21.4%), Los Angeles (20.1%) and Chicago (23.0%). By total square feet, metros with the most maturing debt are Washington, D.C. (70.5 million), Manhattan (68.5 million), Chicago (60.6 million), Los Angeles (59.3 million) and Atlanta (59.1 million). Markets with the highest vacancy rates as of April 2023 are Detroit (22.5%), Austin (22.0%), Houston (21.5%), Denver (19.9%),
Atlanta (19.7%) and Hartford (19.6%).
Five metros have at least 20% of industrial stock with maturing loans between now and 2025: Columbus (24.7%), Atlanta (22.4%), Kansas City (21.4%), Memphis (20.9%) and Phoenix (20.0%). Industrial markets with the most amount of square feet of maturing loans are Chicago (99.2 million), Atlanta (88.8 million), Dallas (87.3 million), the Inland Empire (79.48 million) and Columbus (45.3 million). Markets with the highest vacancy rate as of April 2023 are Houston (8.4%), Boston (6.9%), Denver (6.7%), Minneapolis (5.7%) and Memphis (5.6%).
Industrial Loan Maturities by Metro/Vacancy Rate, 2023-2025
Delinquencies Low but Rising
Coming at the tail end of a long bear market fueled by low interest rates and strong property performance, delinquency rates are low. Only 2% of commercial mortgages held by all lenders were delinquent at year-end 2022, according to the MBA. By property type, the highest delinquency rates were in lodging (6.1%) and retail (5.4%), per the MBA, while rates were lower in office (1.6%), multifamily (0.5%) and industrial (0.3%).
Evidence of distress is starting to appear, albeit slowly. The percentage of CMBS loans in special servicing has edged up in recent months to 5.6% in April, which is down from the 10.5% peak during the height of the pandemic but double the 2.7% pre-pandemic level, according to Trepp. The CMBS delinquency rate as of April 2023 was 3.1%, up almost 100 basis points from before the pandemic but far below the 10.3% peak in June 2020, per Trepp and the CRE Finance Council.
Market conditions including rising interest rates and capital costs are taking a toll on property values. Public companies react much more quickly to market developments. The NAREIT Equity REIT Index dropped 24.4% in 2022 and was relatively flat (up 2.1%) in 2023 through early May. Appreciation returns in the National Council of Real Estate Investment Fiduciaries (NCREIF) Property Index were -6.3% year-over-year through 1Q 2023. Private property indexes typically take several quarters to react to drops in pricing, so private indexes almost certainly will drop further.
Investors believe the worst is yet to come. More than half of private equity investors view properties as overvalued and expect value to drop further, according to a recent survey of 150 investors by Preqin, which tracked $123.3 billion raised for value-add and opportunistic investments in 2022. The share of opportunistic and value-add capital was 67% of all funds raised, the highest level since 2015.
Industrial Maturities 2023-2025 by Metro
Factors That Determine Distress
Given the drop in property values and tightening loan underwriting, refinancing mortgages with the same level of proceeds will be difficult for some property owners. How much distress that creates will depend on numerous factors, including:
The performance of commercial property types has diverged sharply in recent years, which is reflected in CMBS special servicing data. The percentage of loans in special servicing as of February was 4.4% for office, 2.7% for multifamily and 0.4% for industrial. Property types such as multifamily, industrial and niche sectors such as self-storage, data centers, life science and student housing have had strong demand and income growth. Industrial in-place rents boomed in recent years, up 7.2% year-over-year as of April 2023 and 12.1% since January 2021.
Office and retail, on the other hand, are facing long-term changes and waning demand based on major disruptions. Demand for offices and retail space is deteriorating due to the work-from-home revolution and online shopping. Big-picture retail vacancy rates look benign but mask the potential for high delinquencies resulting from individual malls becoming obsolete or properties with retailers that go out of business. Malls have had to reinvent themselves away from clothing to more experiential uses such as restaurants and gyms, and some transition more successfully than others.
The national office vacancy rate has increased by more than 3 percentage points since the start of the pandemic and was up to 16.7% as of April, with 121 million square feet of space being subleased. Although there is considerable variation depending on submarket and building vintage, the office vacancies will increase as long-term leases expire and companies downsize. The problems for offices are magnified by the fact that investors and lenders are avoiding booking office investments out of fear that demand will continue to spiral downward.
Office Maturities 2023-2025 by Metro
Office REITs have been harder hit by falling values than their property-type peers, a signal of the market’s bearish sentiment. Office REIT values were down 47.7% through early May year-over-year, while the total NAREIT index fell 17.2%. During that time, residential REITs were down 18.7% and industrial 11.3%. If REIT stocks are a directional signal, private office property values have further to fall in coming years. More than 80% of investors surveyed by NCREIF expect write-downs in office properties.
Within property types there is a variance in performance depending on markets/submarkets. Some office markets have held up better post-pandemic due to the industry composition of the office tenants or the percentage of workers that go to the office regularly. Vacancies have more than doubled since the start of 2020 in the largest office markets in San Francisco (19.4%) and Manhattan (16.4%). At the same time, a steady stream of businesses continues to move to or expand in metros such as Miami and Dallas.
Submarkets with newer stock are likely to outperform. Properties built since 2010 with key amenities such as energy-efficient HVAC, high-level connectivity, kitchens and fitness centers are attracting tenants at the expense of B- and C-quality properties. Newer properties have registered positive absorption since the pandemic started, while net absorption is negative in older buildings.
Many loans that were originated more than five years ago, particularly in high-rent-growth property types have had the benefit of income growth. The average new industrial lease has increased by 25.9% to $9.24 per square foot since January 2021. In high-growth segments, conservative underwriting is counteracted by rising rent growth.
Seasoning also comes into play related to the market conditions when a maturing loan was last financed. Loan coupons today are higher than they have been in 15 years or more, but rates have fluctuated over the last decade and declined to extraordinarily low levels between late 2020 and early 2022.
That means different loans will have more or less of a gap to fill based on the current rate relative to the rate at origination. Rate type also comes into play, as adjustable-rate loans are often more expensive than fixed rates. The 10-year Treasury jumped as high as 4.5% in the fall of 2022 but was down to 3.4% as of early May as bond investors grow more bearish about the economy. Meanwhile, the floating-rate SOFR benchmark index has held at about 4.8%.
The upshot is that candidates for distress will be concentrated in office and (to a lesser degree) properties in classes with structural demand issues or some combination of other factors that include:
- Being financed with short-term variable-rate debt in recent years.
- Not meeting expectations of income growth.
- Facing a steep increase in interest rates or unable to afford to buy a new interest rate cap.
- Having no strategic value to the owner.
Is There Systemic Risk Again?
Although there is a high probability that distress will increase, it is less likely to create systemic issues like the last down cycle in 2008-2010. Too-big-to-fail banks seem well-capitalized, despite high-profile regional bank failures. And while underwriting has become more lenient in recent years, when one looks at metrics such as debt-service coverage and loan-to-value ratios, lenders did not get as aggressive as they did in the 2005-2007 period, when it was common for acquisitions to be financed with 90% or more leverage and multiple layers of junior debt.
Another variable is the strategies of borrowers and lenders. Some owners are strategically walking away from assets that are underwater. Most properties that have higher mortgage payments than cash flow — debt-service coverage of less than 1.0 — do not default because owners hope to turn the property around or keep a stream of management fees. But some large owners are handing over keys to properties that are not core to their portfolios, among other reasons.
The inverse is true, as well. Dealing with maturity defaults, banks must decide whether to pursue foreclosure or negotiate extensions with borrowers. A massive number of underwater loans were extended for years past maturity in the post-GFC period as banks adopted an “extend and pretend” strategy. There are downsides to this posture for banks, but foreclosures were avoided and many of the loans recovered as the economy improved.
Banks facing maturity defaults today are much more likely than they were in 2008-2010 to take a harder stance and demand an incentive from the borrower, such as a paydown of the loan balance or an increase in reserve funds, before agreeing to an extension. However, lenders probably have little appetite to force foreclosures and spur rapid growth in distress.
Finally, an overarching factor in this discussion is the performance of the economy and possible exogenous events (such as a debt limit default by the U.S. government). A year into the Federal Reserve’s interest-rate-hike cycle, key indicators of commercial property demand, such as the job market and consumer spending, remain healthy. However, if the widely forecast recession finally arrives or the economy is jolted by a shock, the depth and duration of that episode will play a key role in the level of commercial property distress.
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The U.S. office vacancy rate reached 17.5% at the end of August, rising 260 basis points over year-ago figures.
Loans on 18.1% of Class B assets — encompassing 594.2 million square feet — will reach maturity by the end of 2026.