Office loans 'living on borrowed time'

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The bill could soon come due for mortgages on commercial properties whose valuations have taken a dive since Covid-19.

See the following chart from Goldman Sachs:

The notable change is how much the 2024-maturity bar grew in just a year. About $270bn of last year’s commercial mortgage maturities were delayed until this year.

For borrowers, there’s a clear reason to delay. With US rates above 5 per cent, refinancing these mortgages is an expensive proposition at best, and at worst is simply not feasible. Across the entire CRE market, refinancing costs are the highest they’ve been in at least 20 years, says GS.

And lenders agreed to “extend and pretend” (ie modify loans) because the alternative is foreclosing on office properties valued far below where they were when those loans were originally made.

How far below? On average prices have dropped 33 per cent, and in some areas they’ve slid more than 60 per cent, says GS, citing Real Capital Analytics:

For lenders, modifications and extensions are still better alternatives to foreclosures and liquidations, given the current trajectory of property prices. For context, the average sales price for US offices has fallen by 33% since the 2019 peak on a per square foot basis, according to data collected from Real Capital Analytics (RCA). Central business districts of some cities like as Seattle, Los Angeles, and San Francisco, where distressed sales represent a large share of transaction volume, have seen average office sales prices fall by over 60% since the start of the pandemic, discounts that lenders are likely unwilling to accept.

All of this begs the question, says GS: How much longer can borrowers modify loans and extend maturities before lenders start demanding repayment or foreclosing on properties?

The problem is that with each slightly high US inflation print, a quick pace of Federal Reserve rate cuts looks ever less likely. Sharply lower rates are what could possibly save US commercial property markets from a broader reckoning.

And regional banks, which have had their own issues with high interest rates (cough-deposit-costs-cough) in the past year, are among the biggest players in the market. From GS:

For balance sheet-constrained lenders, the ability to amend and extend loans could also diminish over time. This is particularly the case for regional banks which have to cope with rising credit losses in CRE portfolios. Banks hold almost half of CRE loans maturing in 2024, and our REITs research team estimates that 62% of bank office loans are held by regional/local banks. If these banks experience renewed balance sheet pressure, even if the source is unrelated to CRE loan losses, their ability to keep troubled loans on their books will diminish.

GS found that among non-bank lenders, nearly half of 2023’s CRE maturities were pushed into this year:

It’s not just the lenders who might decide that allowing the extend-and-pretend game to continue is just not worth it. The further that office prices decline (into a liquidity vacuum), the more pressure will fall on borrowers to default strategically. From GS:

For borrowers, the benefits from modifying and extending the loans could still fall short of offsetting the downward pressure on net operating income, thereby creating stronger incentives for hard defaults. A further large decline in office property prices could also cause more borrowers to strategically give up on mortgages where the loan exceeds the property value.

In fact, the most recent data from the CMBS market show a steady rise in losses for maturing loans, suggesting more lenders are foreclosing on properties to recover value on defaulted loans.

The silver lining, in GS’s view, is that the banking sector is better equipped to deal with an office-price collapse than it was the home-price collapse before the global financial crisis:

In our view, the risk of negative feedback loop of distressed sales and lower property prices remains largely contained to the office sector, and many banks have already reserved loss allowances for their portfolios of CRE loans at levels we assess as reasonable vs. historical scenarios. Moreover, banks are much better positioned than they were in the runups to the Global Financial Crisis and Savings & Loan Crisis. For context, single-family residential mortgages made up 34% of FDIC-insured bank loan books in 2009, a far higher level than the 9.3% of loan books currently made up by CRE loans.

So it’s less likely there’ll be a systemic crisis that, even after forcing a central-banking revolution, leads to years of US economic stagnation. That’s good.

Further reading: — Colliding with CRE’s maturity wall