Power & Market

The CRE Bust is a Slow-Moving Train


Day-to-day we don’t hear much about the commercial office property crash. As The Fed’s Michael Barr said at an event hosted by the National Community Reinvestment Coalition in Washington, “This is the kind of thing where it’s likely to be a very slow-moving train as the financial sector and commercial real estate market move forward,” he said, adding that refinancing deals will play out in the next few years. “It’ll take some time.”

Barr, the vice chair for supervision said “There are pockets of risks in the system. We’re looking at things like, what’s the level of unrealized losses on the balance sheet from securities? We’re looking at banks that have particular kinds of concentration in commercial real estate.”

 Wolf Richter at wolfstreet.com, citing Trepp, reports the delinquency rate of office mortgages that have been securitized into CMBS rose to 6.6% in February. Given we’re just a year into the office market calamity, it’s just the “beginning because it will take years to get this mess cleaned up. And at this point, it’s still getting worse,” writes Richter. 

The latest Grant’s Interest Rate Observer sees plenty of CRE troubles ahead and starts with the building at 233 Broadway which houses the iconic newsletter on its 24th floor. “Newmark Group, Inc. advises your editor that this, the home of Grant’s Interest Rate Observer, is 33% vacant. As of the Sept. 30, 2023 financials, the building’s net operating income was running at $16.4 million and its debt service at $24.9 million, yielding a debt-service coverage ratio of 0.66. Something— perhaps the 6.84% interest cost of the debt—has to give.” 

Grant’s explains, “Real estate is a proverbially slow-moving asset, and price discovery is proceeding at a snail’s pace.” Daniel McNamara, founder and chief investment officer of Polpo Capital Management, told Evan Lorenz of Grant’s. “I’m sure there are plenty of other office owners that will be walking away from underwater buildings in the next year or so. “There’s also currently a backlog of matured/foreclosed offices that servicers have been unwilling to sell at distressed prices,” McNamara made the point that as loans mature and investors make deals enough market comps will be created “that servicers will be forced to realize the depressed value of their buildings, allowing them to finally offer them for sale. The additional distressed supply should put more downward pressure on prices,” writes Grant’s. 

Commercial mortgage maturities will total $929 billion this year, an increase of 41% from the $659 billion estimate of early 2023, “mostly due to mass extensions of 2023 loans,” according to Newmark Group, which “estimate[s] that $670 billion in debt maturing between 2024 and 2026 is potentially troubled.”

Plus, expenses are increasing. In some cases wildly. Assuming 2%-3% expense increases is a mistake. Costs have “grown at double or triple that pace,” writes Vik Uppal, CEO of Mavik Capital Partners, L.P., specialists in distressed real estate. “Scrutinizing every line item individually has never been more important—or more difficult. Insurance, which used to be one of the most stable line items, has become one of the most volatile, and not because of inflation.” State Farm Insurance has decided to stop insuring multi-family properties in California after regulators granted the company a 23% increase in rates instead of the 38.7% rate increase it asked for.

“I think we’re in the middle innings,” McNamara told Lorenz. “Transactions in the U.S. across commercial real estate were down something like 60% last year....Lenders are going to have to start crystallizing losses. They’re not in the business of owning real estate. So, as transaction activity picks up, people are going to get comfortable with disposing of these assets. That’s what we need.” 

The Wall Street Journal’s Peter Grant recently wrote a piece about the disconnect between increased rents and increased vacancy. Builder owners will do anything to avoid lowering rents to lease space, including, as incongruent as it sounds, leaving space empty. 

Landlords who cut rents significantly to fill empty space “would significantly reduce the appraised values of their buildings,” David Bitner, the head of global research for Newmark Group, told Grant. “This in turn could lead to a covenant default on their loans or at minimum would make it harder for them to refinance.”

But, eventually rents will crumble as will values. Owners and lenders will restructure the mortgages or the properties will liquidated. As Barr said, recognition of the problems in commercial real estate is a slow-moving train. 

Note: The views expressed on Mises.org are not necessarily those of the Mises Institute.
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