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Could the next down turn be commercial real estate?

Will office and retail properties be the next shoe to drop? With new commercial loan originations coming to a halt, the data is inconclusive. However, at a recent MBA conference, Grisele Crespo, Director of Commercial Real Estate Practice at Fortress Risk Consultants noted that the market is twice as bad as it was in 2008.


Significant attention has gone towards office vacancies, however that is only one factor impacting commercial real estate. Rising interest rates, loan maturities and insurance premiums are creating the perfect storm for the broader sector, which includes retail, office, hospitality, healthcare, and multifamily.


Commercial Real Estate Rising Interest Rates & Loan Maturities


Morgan Stanley estimates that $1.5 trillion in commercial real estate debt is set to mature over the next two years. To put this into perspective, as of Q4 2022, there was $4.5 trillion of commercial mortgage debt (MBA), meaning a third of this debt will mature.


Maturing Commercial Loans

Unlike residential real estate, most commercial loans are not fully amortizing. At maturity, the borrower is faced with a balloon payment and has 3 primary paths forward: (1) refinance, (2) sell the property, or (3) negotiate a loan extension.


Options 1 & 2 are unattractive given current market conditions. With high interest rates, operating cash flows are squeezed, as borrowers have locked in leases and revenue. Selling the property may seem like an out, however this just pushes the problem onto a new borrower as the underlying financials for the property remain the same. For this reason property valuations are down around 15% in the past 12 months and transactions have significantly slowed.


This leaves loan extensions as the primary path forward. Many loan agreements allow for loan extensions, however lenders and investors are unlikely to take the full blunt. With around 40% of commercial real estate owned by banks, the sector has flexibility (versus securitizations which limit options).


Commercial Real Estate Insurance Premiums


Rising insurance premiums are also a hot topic within commercial real estate. Carriers are pulling out of markets completely (Florida) and raising premiums to account for more natural disasters & higher costs of construction.


Property valuations are down around 15% in the past 12 months and transactions have significantly slowed

Many borrowers did not account for significant increases in insurance premiums and are cash flow negative given the increased cost.


Servicers are seeing an increase in waiver requests and desire to self-insure, however there is relatively little flexibility lenders can offer while still protecting their interest or abiding by agency and securitization guidelines. Some lenders have considered premium financing (lender makes insurance payment upfront and gets repaid over time), rating condition waivers (removing the need for an insurance carrier to be rated), or parametric insurance (supplemental insurance that pays out a specified amount rather than losses), however none are common practice.


Risk to the overall economy


While commercial real estate had essentially no role in recent bank failures, it is understandable to be concerned about the risk. At the median US bank, 38% of loan holdings are in commercial (KBW Research), and so while borrowers are dependent on banks, banks are very much dependent on their borrowers to perform.

Total Lending Chart

In the coming year we expect to see much greater creativity in structuring loans and deviations in performance for bank held loans versus securitized loans & property type.



 

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