Commercial real estate faces increasing headwinds. Delinquency rates, especially for office buildings, have spiked and show signs of climbing still higher. Developers and lenders are set to lose.
The pain is passing through to those who hold bonds backed by commercial mortgages, the so-called commercial mortgage bond securities (CMBS). There is little sign of relief anytime soon.
The problem lies largely, though not entirely, with the work-from-home legacy of the COVID-19 lockdowns and quarantines. Because office workers especially became accustomed to remote work, they remain reluctant to make their former daily trek to city-center offices. That reluctance has found a powerful reinforcement in rising crime and a marked deterioration in the quality of city life. Firms have begun to adjust so that much space in the great glass boxes downtown lies empty and not earning the rents for which they were built. Developers unavoidably feel the pinch.
That isn’t all. Because the Federal Reserve’s inflation fight has prompted it to raise interest rates, developers can no longer ease pressures by getting better terms in a refinancing. For a while, these developers hung on in the hope that the Fed would change policy soon. But now policymakers have made clear that they intend to raise interest rates still more and hold them at heightened levels until inflation returns to the Fed’s preferred 2 percent target, a long way from recent rates of inflation. With continued pressures and the evaporation of these hopes for a policy change, more developers are giving up, walking away from their projects, and leaving the proverbial keys with the lenders. The pressure, already acute, is set to intensify because this year will see the maturation of the interest-only mortgages that had become especially fashionable in recent years, rising to 88 percent of issues in the past year from 51 percent in 2013.
Figures on the deterioration in this sector are depressing. Office real estate values have declined across the country. In San Francisco, for example, values have dropped 60–70 percent from their peaks of just a few years ago. This city is an admittedly dramatic extreme, but it nonetheless captures how bad things have become, while anecdotal evidence suggests strongly that value declines on city office space have spread out of the big cities and beyond the big projects.
With values falling and rent rolls thinning, delinquency rates on all forms of commercial real estate jumped to 3.6 percent in May (the most recent period for which data are available), up considerably from 3.09 percent in April and 2.99 percent six months ago. Among the different sorts of commercial space, retail continues to be the most troubled, with a 6.67 percent delinquency rate. Lodging is second with a 4.25 percent rate. But the overall May spike was due almost entirely to a sudden rise in delinquencies on office space.
There, the rate hit 4.02 percent in May, a major jump from April’s 2.77 percent rate and a rate of only 1.70 percent six months ago. Only industrial and multifamily delinquencies have remained low.
Anecdotal evidence makes the dry statistics more real. Blackstone, one of the largest real estate developers in the world, has given up on two of its prominent properties: the $350 million loan for a Las Vegas office park and a midtown Manhattan office tower that it bought in 2014 for $605 million. Blackstone also shows signs of walking away from a $274 million loan it took for Club Quarters Hotels in Chicago, San Francisco, Boston, and Philadelphia. These loans have already been transferred to what are called “special services,” a common step with a loan that is headed for default.
The experience of this prominent player is not unique. And it looks as though the pressure will become still more intense. The Mortgage Bankers Association estimates that some $92 billion in non-bank mortgage debt will mature before year-end.
The woes of developers and loan originators have begun to pass through to CMBS investors. Already in May, some 6.2 percent of these securities have transferred to special services, exceeding 6 percent for the first time since 2013. A disproportionate 41 percent of this number involve office properties. Accordingly, overall CMBS delinquencies have risen from 2.88 percent in April to 3.43 percent in May, well above last year’s figure of 2.78 percent.
The horizon holds little promise of relief for office properties, at least not anytime soon. The trend for remote work becomes more firmly entrenched each day. Crime and quality-of-life matters in major cities will take time to turn. Even the Fed promises to take months before even considering a reduction in interest rates. Tough times for office properties seem likely to last.
