By Candice Richardson, CFA, VP of Investments and Analytics, Lido Advisors
Commercial real estate (CRE) woes popped up most recently in 2023, as investors weighed the impact of high rates, office struggles, and regional bank stress on CRE investments. So far, these headwinds have been manageable for the overall CRE market. If one looks at it more granularly however, certain sectors and regions are worth scrutinizing.
Delving into the office sector, it’s clear from the data and fundamentals that office is still in a tough position. Office vacancy rates remain elevated (especially in metropolitan cities), and as a result of higher vacancy rates, office property values have fallen sharply.[1] Certain regions are doing better than others, but the overall story shows weakness and remains concerning.
Some have wondered if it’s economically viable to turn empty office space into apartments, but the office-to-multifamily conversion remains very low as it’s still quite expensive to undertake the conversion. Office CMBS delinquencies are currently at 6.94% as of May and are significantly higher than a year ago.[2] Office delinquencies have slightly stabilized however, as the monthly increase in delinquencies has been mostly steady over the past year. Refinancing needs were elevated this year, however many borrowers have been able to modify their loans as modification rates have been growing.[3] From Q3 2022 to Q32023, there was a 9X increase in loan modifications, with the most modifications (~42%) coming from the office sector.[4] Despite these modifications, default rates for the office space are up significantly year-to-date. In 2023 the office default rate was 20%, and in Q1 of this year alone, the default rate increased to 39%.[5] The office sector could be close to reaching peak stress, however it’s still too early to tell.
Looking at delinquency rates for the overall market, the overall CMBS delinquency rate was 4.97% in May, the second highest rate since September 2021 when the rate was 5.35%.[6] The increase in May was mainly due to increases in lodging and multifamily delinquencies. Multifamily has a large amount of loans maturing in 2024, however multifamily delinquencies remain relatively low and most of them have been in the senior and student housing segments rather than conventional multifamily.[7] One note of caution however is that the pipeline of multifamily properties under construction has dropped considerably, which could suggest weak tenant demand and thus weaker rental growth going forward.
Despite higher rates and worries of a lending shortfall from regional banks, year-over-year (YoY) CRE loan growth is still positive. Surprisingly, in the past year most of the CRE loan growth came from smaller banks rather than large banks. Smaller banks have grown their Commercial & Industrial (C&I) loan books by 5%, and their multifamily loans have grown roughly 10%.[8] Meanwhile, the 25 largest banks have increased their C&I loans by 4% and their multifamily books by 1%.[9]
Although many borrowers have been able to take advantage of modifying and extending their loans into more lender-friendly terms, the maturity wall is still a problem. The percentage of loans that have initial maturities in the next two years is the highest amount on record, with over 30% of CRE loans maturing over the next two years.[10] Part of the reason for the large amount of maturities is due to the pick-up in extensions for loans that were scheduled to mature last year, which has pushed out the maturities slightly. Loan modifications and extensions will likely continue in the short-term, but there may come a point where banks would rather sell these loans at a discount than keep the troubled loans on their books. 93% of modifications have been extensions, and if these loans are still in trouble when their next maturity date comes, banks may be reluctant to offer another extension.[11]
Providing that rates drop notably next year, with the reason being that inflation is close to 2% and not because we entered a recession, delinquencies and defaults are likely to remain manageable. But if we remain in a high for longer rate environment well into 2025, then we could see significant distress in the CRE market, particularly in the office sector. As such, we remain cautious on the near-term outlook for the space.
[1] Viswanathan, V. (2024). Commercial Real Estate Monitor: Plenty of headwinds but the construction pipeline is not one of them. Goldman Sachs.
[5] https://www.fitchratings.com/research/structured-finance/accelerating-office-retail-defaults-drive-overall-rates-higher-04-06-2024
[7] Ashworth, R. (2024). Commercial Real Estate Monitor: Multifamily performance in focus. Goldman Sachs.
[8] Karoui, L. (2024). US CRE, one year later: Volatile, dispersed, but not systemic. Goldman Sachs.
[9] Ibid.
[10] Ibid.