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Over the past six months, we have covered the broad tumult facing the real estate sector (VNQ). Following an unprecedented era of rising interest rates, real estate has struggled to find its footing in a radically different financial environment. We have discussed factors contributing to the broad increases in distressed assets across asset classes and warned of the upcoming wall of maturities.
In February, we wrote an article titled “Commercial Real Estate Could Be At A Tipping Point.” The article highlighted a substantial wave of loan maturities in 2024/2025. More specifically, we pointed to parallels leading to the Great Financial Crisis including an overly confident Federal Reserve. Six months later, we have seen no rate cuts and inflation remains well above the Federal Reserve’s target rate.
As a follow-up, we published an article in May titled “Commercial Real Estate Distress Rates Continue To Rise And Here’s Why…” discussing rising distress rates across asset classes. Additionally, we explored a case study of a high quality multifamily asset located in our nation’s capital which was currently underwater, financially. The article outlined potential issues including valuation compression, inflation, and other macroeconomic factors currently pressuring multifamily assets, specifically.
Today, we are going to dive back into the discussion and provide an update on commercial real estate. Specifically, we will discuss the Federal Reserve, the continuation of elevating distress rates, and the outlook for the remainder of the year.
Federal Reserve Update
The Federal Reserve meeting was the talk of the town in June as investors gauged the possibility of changing interest rates. For the seventh consecutive month, the Federal Reserve left the target range for the federal funds rate unchanged. The present range of 5.25%-5.50% is well above the average over the past ten years.
Data by YCharts
At the meeting, Federal Reserve Chairman Jerome Powell provided commentary that the May CPI report surpassed expectations but fell short of the necessary prerequisites to change borrowing costs.
CPI slowed modestly to 3.3% on a year-over-year basis, moving ever so slowly towards the Federal Reserve’s 2% goal. The Federal Reserve provided commentary:
The Committee decided to maintain the target range for the federal funds rate at 5-1/4 to 5-1/2 percent…The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent. In addition, the Committee will continue reducing its holdings of Treasury securities and agency debt, and agency mortgage‑backed securities. The Committee is strongly committed to returning inflation to its 2 percent objective.
CME FedWatch provides ongoing forecasts of shifts in the federal funds rate. Prior to the meeting, the forecast predicted a nearly 99% chance that rates would be unchanged. The Federal Reserve is next scheduled to meet at the end of July to again reassess rates. Similarly, the tool forecasts a >90% chance that interest rates will remain unchanged. A small chance of a 25 basis point cut remains.
Looking forward to the end of the year, rate cuts begin to appear more likely. At the beginning of the year, the consensus landed that rate cuts would arrive by summer and multiple cuts were all but certain. As we finish the second quarter of the year, no rate cuts have arrived and the forecast has dried up to a single cut by year-end.
In fact, another forecasting tool provides an even less optimistic outlook for changes in interest rates. The Federal Reserve publishes a “dot plot” on a quarterly basis that gauges the forecasts of FOMC members for interest rate changes. The most recent dot plot suggests interest rates will remain virtually unchanged through year-end. More significant changes to interest rates will materialize in 2025 and 2026. Thereafter, rates will likely stabilize alongside long-term inflation in the 2%-3% range.
Importantly, there are no forecasts that interest rates are likely to increase over the next several years. This alleviates critical pressure for real estate. However, the longer that interest rates are held high, the more pressure is put on real estate as the industry faces increasing pressure.
Unfortunately, this means…
Distress Rates Are Still Rising
In our article from April, we explored rising distress rates across Commercial Real Estate Collateralized Loan Obligations or CRE CLOs. We provided an overview of CRE CLOs including their structure, function, and underlying assets. We also discussed an unprecedented increase in distress rates for these complex securitized portfolios of commercial-backed mortgages.
Since the publication of that article, the trend has continued and distress rates broadly have continued to rise. In the month of April, CRED iQ’s distress rate for all assets reaches a new all-time high of 8.35%. CRED iQ’s distress rate increased from 7.61% to 8.35%, a 74 basis points jump in the month of April alone. Today, distress rates continue to rise across most asset classes except the most insulated such as industrial. Major asset classes such as multifamily, retail, office, and hotel each increased during the month of April.
Multifamily saw the most significant increase of any single category, increasing to 7.2% for the month of April, an increase of 3.5% month over month. According to CRED iQ, the increase is primarily attributable to a single loan in San Francisco:
The increase is mostly attributable to a $1.75 billion loan ($561,000/unit) backed by Parkmerced, a 3,221-unit multifamily property in San Francisco. Imminent non-monetary default caused the loan to transfer to the special servicer with the looming maturity date of December 2024. Furthermore, the assets have been underperforming with a below break-even DSCR of 0.47 and 83.5% occupancy… Parkmerced consists of a mixture of townhouse and tower apartment units spanning 152 acres. Approximately 17% of the units were leased by students at origination in 2019, as the property is across the street from San Francisco State University. Parkmerced was underwritten for $2.1B ($655,076/unit) in September 2019.
In the previous article, we specifically cued in on multifamily as the most troubled asset class. We wrote:
As rates bottomed during the pandemic recovery, financing and development costs for real estate dropped significantly. The advantageous financing environment encouraged a wave of development, supporting most asset classes across most regions. Cheap financing paired with compressed transaction capitalization rates formed an underwriting nirvana. Nearly every development or acquisition opportunity was financially viable when interest rates were zero and properties traded at their most aggressive historical valuations….Rising market rents and unaffordability of homeownership have acted as significant performance drivers for multifamily investors over the past several years. However, the aforementioned factors have led to overbuilding over the past several years… Many newly delivered assets including high quality properties are underperforming due to oversupply.
As the troubles continue to materialize, multifamily assets are becoming a concentrated pain point. Multifamily and industrial were the two most aggressively underwritten asset classes in the post-pandemic zero interest rate policy era. However, there has been a critical difference causing the massive divergence in distress rates for the two asset classes. At the asset level, industrial delivered as promised and multifamily fell short.
Industrial properties have performed exceptionally well with either long-term underwritten leases or extraordinary market rent growth powering strong leasing spreads. Industrial owners have seen a double benefit over the past several years. New properties are leased up quickly due to strong demand. Properties vacated due to either bankruptcies or lease expirations had their vacant spaces rolling into a much higher market rent, increasing property level cash flow significantly.
In contrast, multifamily was largely overbuilt in primary markets causing oversupply. With too many units and not enough demand, market rent did not increase as expected over the past several years. This means asset-level cash flow fell short of underwriting expectations and distress rates have begun to rise.
Other asset classes are continuing to struggle alongside multifamily. Office continues to suffer more than most asset classes at 11.7%, a further increase over the prior month. Surprisingly, retail has surged to the top position at 11.9%, an increase of 2.4% over the prior month. Hotel distress rates continue to increase similarly.
With distress rates rising across most asset classes, lenders and borrowers have been hard at work finding solutions. The most common solution thus far has been through loan modifications.
Loan Modifications Are Increasing Even Faster…
Over the past six months, “extend and pretend” has been a recurring phrase in our writing. This catchy phrase is used to describe the process under which non-performing loans are modified or extended to ignore their asset-level issues. For borrowers, this keeps them financially stable. For lenders, this prevents a massive wave of repossessions of poorly performing assets.
As of May 31, the average volume of loan modifications year-to-date was $1.8 billion. April was the highest month in terms of activity with over $3 billion in loan modifications. The volume of modifications last year more than doubled compared to 2022. Year-to-date modifications are running slightly higher than their 2023 averages as we settle into the wave of maturities. Around $22 billion of loans have been modified in the past 12 months according to CRED iQ. Compared to the 2023 total modification volume of around $17 billion, this year is on pace for a significant increase.
Almost half of the modifications in the month of May were maturity extensions. Again, refer to the monicker “extend and pretend” for an explanation. To better understand what this strategy looks like in a practical sense, let’s explore a case study from CRED iQ:
The $63.9 million loan backed by the 412-unit Retreat at Riverside multifamily property in the Atlanta market was modified in May 2024. The loan was originally scheduled to mature in May 2024 but was extended by two months to July 2024. Life safety issues and upcoming maturity lead to the loan being on the servicer’s watchlist since June 2023. At underwriting in February 2021, the asset was appraised at $81.3 million ($197,330/unit). The property was 93.4% occupied with a 0.78 DSCR as of March 2024.
Retreat at Riverside is a large multifamily asset in Atlanta, GA with 412 units. The property was constructed in 1996 and was appraised in February 2021 at $81.3 million. The $63.9 million dollar loan was originated in January 2021 which implies a loan-to-value ratio of approximately 79% as of underwriting. The loan-to-value ratio is consistent with industry standards, however, the property fell to a 78% debt service coverage ratio as of the first quarter. This implies that property-level performance has fallen significantly short of appraised forecasts. Based on current performance, this implies a value reduction of approximately 30%-40% if the property were to be reappraised at current performance.
One saving grace for scenarios such as this would be cuts to the federal funds rate. Commercial loans are floating rate which means declining interest rates are a short-term solution to poor asset-level performance. In this case, debt service coverage ratios would improve as interest rates decline as opposed to cash flow increasing. However, a small rate cut is forecasted over the next six months which simply may not be enough to help situations like Retreat at Riverside.
Investor Takeaways
Cracks are continuing to emerge across commercial real estate. While the cream of the crop has been able to avoid rising distress rates, most asset classes are coming under pressure. As general distress rates increase and the Federal Reserve is slow to cut rates, lenders and borrowers are both coming under similar pressure.
The freight train has been approaching for some time, spurring a wave of modifications across commercial assets. With tens of billions in loans modified over the past twelve months, the market is hard at work to use “extend and pretend” to solve the impending issues. As they say, it is never the punch you see coming that gets you, but the tsunami caused by rising interest rates is proving too strong to ignore.