The Real Estate Reel: Fact vs. fiction in commercial real estate debt

 
Rich Hill

Rich Hill

Head of Real Estate Strategy & Research

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5 minute read

March 2024

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Recent headlines have sparked questions about the health of the commercial real estate market. But data from lending standards, CRE mortgage maturities, and loan defaults can help separate fact from fiction.

KEY TAKEAWAYS

  • Distress is still on the rise in commercial real estate debt. But a closer look at lending standards, CRE mortgage maturities, and loan defaults support why we think distress is likely to be less severe than feared.
  • Reduced lender tightening suggests a slowdown in CRE property price declines, while nearly 40% of loans that were set to mature in 2023 have been extended or otherwise modified and will now mature in 2024 and beyond.
  • We don’t expect loan defaults to be as great as feared, especially given distress varies across property type and lender type.

Lending standards, CRE mortgage maturities. And commercial real estate loan defaults.

I’m watching trends in commercial real estate debt this month.

Recent headlines indicate the financial press is also watching CRE debt, sparking questions about the health of the commercial real estate market. But let’s separate fact from fiction.

First, I’m watching lending standards as measured by the Federal Reserve’s Senior Loan Officer Opinion Survey.

The most recent survey showed a nearly 25 percentage point decline in the net percentage of lenders reporting tightening in the fourth quarter of last year. To be clear, lending standards are still tightening; just not as much as they were previously.

We think a big driver of that decline was the 10-year treasury rates dropping nearly 70 basis points over the last 3-months of the year, which, in turn, was a tailwind for improving financing costs as credit spreads moved lower.

Lending standards
Bank lending standards a leading indicator for CRE prices
Bank lending standards a leading indicator for CRE prices

Reduced lender tightening suggests a slowdown in CRE property price declines. Indeed, there is a strong historical relationship between year-over-year changes in CRE prices and the Senior Loan Officer Opinion Survey, which you can see in this chart. The decline in tightening is also consistent with our view that CRE prices will bottom within the next 12 months.

The decline from 66% to 41% is the third largest drop in tightening standards since the early 1990s. It trails only the bounces that occurred in late 1998 and then at the end of 2020, coming out of COVID. Notably, the improvement was broad based across both large and small banks as well core commercial real estate, multifamily and construction lending.

Second, I’m watching mortgage maturities. New data from the Mortgage Bankers Association shows that the volume of maturing loans in 2024 jumped 41%, to almost a trillion dollars this year. This headline may seem startling, but we think it deserves some further explanation.

Mortgage maturities
41% of loans maturing in 2023 were modified or extended

Debt by property type ($)

Mortgage maturities

The concern is that the so-called “wall of maturities” will impede borrowers’ ability to refinance or modify maturing loans in a higher-cost and more restrictive mortgage market. This would put further pressure on commercial real estate prices. This concern is especially pronounced for office, but office represents only 22% of loans maturing in 2024 and only 16% of outstanding commercial mortgages.

We think even labeling it a maturity wall is a mischaracterization; it’s really nothing more than a standard maturity schedule. Consider that mortgages have a seven-year-weighted average maturity, which means that on average 15% of loans come due every year or 45% over a three-year time period. It’s not remarkable by comparison to the 42% of the $4.7tn in outstanding CRE mortgages is coming due over the next three years.

More importantly, we think the focus on the volume of maturing loans in 2024 misses the mark. This is because many loans that were set to mature in 2023 have been extended or otherwise modified and will now mature in 2024 and beyond.

Specifically, extensions and modifications pushed the amount of CRE mortgages maturing this year from $660bn to $929bn. That means $270bn of loans were modified and/or extended in 2023. Given that $729bn of loans that were scheduled to mature in 2023, that means almost 40% of these loans modified and/or extended.

We think that’s a good outcome given the risk of imminent defaults that was feared this time last year. And we expect that as loans come due in 2024, a similar amount will be modified or extended. Bottom line, we think a more orderly workout process mitigates the bear case scenario for commercial real estate property price declines.

This brings me to my final point: commercial real estate loan defaults. There is a constant drumbeat of headlines on this topic, but even though CRE distress is rising, we don’t expect it to be as great as feared.

Commercial real estate loan defaults
~80% of CMBS paying off on time

Debt by property type ($)

Commercial real estate loan defaults

For one thing, approximately 80% of commercial mortgage-backed securities loans that were originally scheduled to mature in 2023 paid off at or before their maturity date.

Yet, you’ll often hear a much different percentage quoted for loans that are still outstanding on their maturity date. This is misleading because higher quality loans typically pay off early and often aren’t factored into the number of loans outstanding.

That said, delinquencies are rising across every lender type, and we expect them to continue to rise through 2024. Total distress stands at approximately $86bn as of the end of 2023, after rising for six consecutive quarters. This is the highest level since 2013. However, this data also deserves a closer look given it varies across property type and lender type.

By lender type, delinquencies rose 149 basis points year-over-year for CMBS securities to 4.3 percent. But CMBS represents only 16% of loans by lender type. By comparison, banks represent less than 40% of loans by lender type, and bank delinquencies rose just 36 basis points year-over-year to 0.8 percent. Fannie Mae rose 28 basis points to 0.54 percent while Freddie Mac rose 11 basis points to 0.24 percent. Delinquencies rose 23 basis points to 0.32 percent for loans held on life company balance sheets.

Delinquencies by property type have ranged from 0.2% for industrial to a maximum of 6.6% for office, which is at the center of the storm given delinquencies have risen 500 basis points year-over-year.

Yes, there are risks, and distress is still on the rise. It’s one of the key reasons we believe commercial real estate prices will fall another 5 to 10 percentage points this year. But we think distress is likely to be less severe than feared.

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ABOUT THE AUTHORS
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Rich Hill, Senior Vice President, is Head of Real Estate Strategy & Research, responsible for identifying allocation opportunities in both listed and private real estate and related thematic and strategic research.

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