Commercial real estate continues to face a growing number of challenges, from inflation to geopolitical events to the Fed’s ‘higher for longer’ interest rate outlook. All these factors have an impact on sales volume, pricing, debt, and refinancing. So where does distress manifest from in the commercial real estate world?
Overall, commercial real estate fundamentals, except for the office sector, seem in check, at least on the capital stack side of the equation. Per Trepp there was $5.9 trillion dollars of outstanding commercial mortgages in the US as of the Q4 2023. According to the Mortgage Bankers association $929 billion dollars across all asset types, exclusive of CMBS loans, will mature in 2024, or a 28 percent increase from 2023. Trepp estimates that roughly $1.7 trillion (or nearly 30 percent) of outstanding debt is expected to mature from 2024 through the end of 2026 with the largest share of maturing loan volume being multifamily at approximately 33 percent. This wall of maturities means that many owners will have to refinance at higher interest rates.
The Federal Reserve is watching commercial real estate borrowing more closely as a potential risk to financial stability. They note the potential for loan defaults and inability to refinance given a correction in property values. MSCI distress tracker reported there was $85.8 billion of in sight distressed real estate in 2023, however they report that distressed sales only represented just a 1.7 percent share of the US investment market in 2023. There is significant capital eagerly lining up to take advantage of this market dislocation. According to Preqin, there is roughly $260 billion in capital that is targeting North American real estate investment. That level is down from the high-water mark of $283 billion in 2022, but still a sizable volume by historical standards.
Over the past two years lenders have been amenable on repayment flexibility and loan modifications. Many commercial real estate loans that became stressed in 2023, got extensions where banks simply “kicked the can down the road” or undertook an “extend-and-pretend” loan workout strategy. Banks were generally willing to work with borrowers over the period of rising interest rates, as all parties view an asset going to the bank as REO an outcome that benefits no one. So now in 2024 major banks are setting aside reserves for delinquencies as they prepare for the potential of recognizing commercial mortgage losses.
The risk of default is a debt dilemma facing real estate mortgage holders. Many defaults to date can be traced to investors who bought assets with short term floating rate debt to finance their purchases. Both banks and borrowers are going to have to deal with the properties that have lost substantial value below that of loan balances. Faced with these issues assets will become financially distressed and go into workout, special servicing, or default. If lender loan loss projections increase this could lead to tighter lending availability and a rise in loan sales, foreclosures and forced sales.
Timing the market bottom is difficult if not impossible. But with billions of patient investment dollars earmarked for commercial real estate sitting on the sidelines for two years some are seeing green shoots of investment activity ramping up. Some like Blackstone, sitting on $191 billion of dry powder, see an upcoming recovery in the commercial real estate market. They deployed almost $25 billion in Q1 2024, or double that of Q1 2023.
Transaction activity is the best measure of any impact on property values. A buyer/seller bid/ask spread and declines in credit availability have seized up transaction activity despite solid market fundamentals for most property types. There was a 50+ percent decline in transaction volume from 2022 levels. Asset values adjusted to the higher rate environment as prices accordingly adjusting downward since the second half of 2022.
The appetite for commercial real estate remains high with a large amount of amount of eager money sitting on the sidelines. Nonetheless transaction activity in Q1 2024 was subdued being down by more than 20 percent vs. 2023 levels. There is hope that Fed rate cuts come in September. With greater liquidity in real estate markets and more market clarity these should prove to be good signs for investors to search for buying opportunities.