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Mortgages on commercial properties, whose valuations have plummeted since the COVID-19 outbreak, may soon come due.
Take a look at this chart from Goldman Sachs:
The notable change is how much the 2024 maturity standard has expanded in just one year: About $270 billion of last year's commercial mortgage maturities were deferred until this year.
Borrowers have a clear reason to hold off: With U.S. interest rates above 5%, refinancing these mortgages is costly at best and downright infeasible at worst. Across the CRE market, refinancing costs are the highest they've been in at least the past 20 years, according to GS.
And the lenders agreed to “fake extensions” (i.e., modify the loans) because to do so would have meant foreclosing on office properties worth much less than they were worth when the loans were originally written.
How much are they down? Average prices are down 33 percent, with some areas dropping by more than 60 percent, GS said, citing Real Capital Analytics.
For lenders, alterations and expansions remain a better alternative than foreclosure or liquidation, given the current trajectory of real estate prices. For reference, the average sales price of U.S. office space per square foot has fallen 33% since its 2019 peak, according to data collected by Real Capital Analytics (RCA). In the central business districts of some cities where distressed sales account for a large percentage of transaction volume, such as Seattle, Los Angeles and San Francisco, the average sales price of office space has fallen by more than 60% since the start of the pandemic, making lenders likely less willing to accept discounts.
GS says all this raises the question: How long can borrowers modify their loans or extend repayment terms before lenders start demanding repayments or foreclosing on properties?
The problem is that every time U.S. inflation spikes a little higher, a quick rate cut from the Federal Reserve becomes less and less likely. Only a sharp drop in interest rates could save the U.S. commercial real estate market from a widespread reckoning.
And regional banks, which have had their own issues with high interest rates (e.g., deposit costs) over the past year, are among the largest players in the market. From GS:
For balance sheet constrained lenders, their ability to modify or extend loans may also decrease over time. This is especially true for regional banks, which must contend with rising credit losses in their CRE portfolios. Banks hold nearly half of the CRE loans maturing in 2024, and our REIT research team estimates that 62% of bank office loans are held by regional banks. If these banks experience renewed balance sheet pressure, even if the cause is unrelated to CRE loan losses, their ability to keep problem loans on their books will decrease.
GS found that among non-bank lenders, nearly half of 2023 CRE maturities have been postponed to this year.
It is not just lenders who decide it is not worth continuing the delinquency and charade game. The further office prices fall (and liquidity disappears), the more pressure borrowers will be under to strategically default. From GS:
For borrowers, the benefits of loan modifications and extensions may still be insufficient to offset the downward pressure on net operating income, creating a strong incentive for hard defaults. Further significant declines in office property prices could also lead to more borrowers strategically abandoning mortgages where the loan amount exceeds the property value.
Indeed, the latest data from the CMBS market shows a steady increase in losses on maturing loans, suggesting that more lenders are foreclosing on properties to recoup value from defaulted loans.
The silver lining, in GS's view, is that the banking sector is better equipped to deal with the collapse in office prices than it was during the house price crash before the global financial crisis.
In our view, the risk of a negative feedback loop of bad loan sales and falling property prices is primarily limited to the office sector, and many banks have already built up loss reserves on their CRE loan portfolios at levels that we believe are reasonable relative to historical scenarios. Moreover, banks are in a much better position than they were just prior to the Global Financial Crisis and the savings and loan crisis. For reference, in 2009, 34% of the FDIC-insured bank loan book was single-family mortgages, much higher than the 9.3% of the loan book that is currently made up of CRE loans.
So even after forcing a central bank revolution, we are less likely to see a systemic crisis that would lead to years of stagnation in the U.S. economy. This is a good thing.
References:
— Hitting the wall of CRE maturity