Challenging market conditions have weighed on the commercial real estate market in recent years. It has been nearly two years since the Federal Reserve (Fed) started raising interest rates. Over the course of 11 meetings (20 months), the federal funds target rate moved up 525 basis points (bps). As a result, the commercial real estate market has been in a state of unease. Transaction volume in 2023 declined sharply as interest rates increased amid economic uncertainty.1 Current commercial real estate mortgage rates are at the highest levels since 2001 and the basis between the originated coupon versus the maturing coupon is widening.2
Today’s Chart of the Week highlights the maturity schedule by property type for commercial mortgage-backed securities (CMBS) conduit loans in 2024 and 2025. Elevated interest rates combined with declining property valuations will continue to keep refinancing conditions strained for commercial real estate borrowers. Approximately $35 billion of conduit loans are set to mature in 2024 and $42.6 billion in 2025. According to Bank of America, 77% of CMBS conduit loans scheduled to mature in 2023 successfully paid off.3 An increasing number of CMBS loans may be unable to refinance at maturity this year as interest rates today are meaningfully higher than when the loans were originated.
Maturity defaults are likely to rise this year, contributing to an increase in the delinquency rate. Valuation pressure could also contribute to an increase in term defaults, as borrowers may be less inclined to support underwater loans in the event of a cash flow disruption. Longer default resolutions may keep delinquencies elevated. CMBS delinquencies rose 147 bps in 2023, ending the year at 4.51%.4 The all-time high was 10.34% in July 2012, while the post-pandemic high of 10.32% was recorded in June 2020.5 Delinquencies will tick higher this year as borrowers struggle to refinance and underperforming properties see higher defaults.
Special servicers will be tasked with handling loans that are unable to refinance, which will have different impacts for credit bondholders. Loans may need to be modified or extended so they can refinance into a more favorable rate environment while borrowers with positive cash-flowing properties will likely put in more equity and receive loan extensions. Higher debt service costs and lower valuations will pressure loan proceeds, causing the payoff rate to decline.
The Fed recently signaled that three 25-basis-point cuts were on the horizon for 2024.6 This could be a signal of property price trough and the road to recovery for the commercial real estate market. The prospect of lower rates could bring relief to CMBS borrowers looking to refinance this year and alleviate maturity and credit concerns.
The maturity wall remains substantial, but many of the loans will see some type of modification. While I expect losses will rise for commercial real estate loans, this increase in defaults is a gradual process as the lengthy workout period and liquidation lags for loans should prolong the resolution of non-performing loans.
Key Takeaway
While headwinds remain for the commercial real estate market that weigh on performance, depreciation is slowing. Unlike prior downturns, there is less leverage embedded in underlying CMBS loans. Much of the debt due over the next few years will be long-term, meaning price growth since origination should provide some flexibility to lenders. Credit fundamentals are likely to drive significant performance across commercial real estate properties in the near term. Higher-quality properties will be better insulated against potential headwinds from elevated delinquencies and rising capitalization rates.
Although the commercial real estate market remains challenged, CMBS will be less affected by a downturn because these holdings are largely investment-grade and have structural protections. Underwriting trends have remained conservative, providing a cushion to absorb the more recent declines in asset valuations. While there are pockets of distress in the office sector, I see stronger fundamentals in most other sectors with limited risk of broad systemic shock. I continue to maintain an up-in-quality bias in well-diversified pools as they offer a better risk/reward profile.
Sources:
1Bank of America – CMBS Outlook; 12/11/23
2Goldman Sachs Research; January 2024
3Bank of America Global Research – Bank earnings transcripts suggest less pessimism, but not yet optimism, on CRE; 1/19/24
4,5Trepp – CMBS Delinquency Rate Falls Slightly to Close 2023, Office Delinquency Rate Posts Rare Dip; January 2024
6CNBC – Fed holds rates steady, indicates three cuts coming in 2024; 12/13/23
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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