Triple-A mortgage bonds are defaulting…look at local banks…even with interest rates being cut, refinance rates will hurt…what to do with your portfolio
In 2014, private equity giant Blackstone purchased the Manhattan skyscraper using $308 million in mortgage financing.
These bonds were AAA rated. The safest bonds. What could go wrong?
By 2022, the Manhattan skyscraper's largest tenant had moved out, leaving 77% of the space vacant. Blackstone no longer saw the math and handed the keys over to its lenders.
Mortgage bond holders, including MetLife and Farmers Insurance, lost at least 25% of their money.
Today, the commercial real estate collapse is spreading to the bond market.
A wave of real estate defaults is raising questions about what will happen to office buildings and shopping malls across the country.
Take the Wall Street Journal from earlier this week.
The bonds, known as single-asset, single-borrower bonds, total about $260 billion and are held by investors including banks, insurance companies, pension funds and mutual funds.
Landlords, often private equity firms, used the money to buy properties such as high-rises and shopping centers.
Much of the debt is coming due and the refinancing market has frozen for many office and retail owners.
Some companies have been defaulting on loans before payments are due because interest costs have soared when the Federal Reserve raised interest rates.
These “SASB” bonds were supposed to be extremely conservative. Credit rating agencies gave many of them triple-A ratings, the highest (safest) rating available. So it's alarming that the rate of defaults or near-defaults on SASB loans has nearly tripled in just two years.
Back to WSJ:
SASB bonds backed by shopping malls and office buildings have already defaulted in Chicago, Los Angeles, New York, Philadelphia and San Francisco.
While some properties are still holding up, they are struggling to find tenants and lower-rated bonds are trading at less than 20 cents on the dollar.
The chart below shows the maturities of SASB commercial bonds: The big spike in the chart shows that $78 billion worth of bonds are coming due in 2026.
Source: Federal Reserve Data/WSJ
Meanwhile, investors should also keep an eye on regional banks.
For the past two years, we have been tracking regional banks in our Commercial Real Estate Watch segment because they account for 67% of all commercial real estate lending, and last month we learned just how much risk exists in this sector.
Researchers at Florida Atlantic University found that more than 60 banks are at risk of failure because of their commercial real estate investments.
From the Florida Atlantic University News Desk:
As reported in first-quarter 2024 regulatory data and shown in the U.S. Bank Commercial Real Estate Risk Exposure Screener, 67 banks have commercial real estate exposure of more than 300% of their total capital.
“This is a very serious development for the banking system as commercial real estate mortgage rates are being reset in a high interest rate environment,” said Dr. Rebel Cole, Lynn Eminent Scholar and professor of finance in the FAU College of Business.
“With commercial real estate selling at deep discounts in the current market, banks will eventually be forced by regulators to write down those exposures.”
While the big banks are not taking on as much risk as regional banks, they are not immune.
Here's a Bloomberg article from May:
Big U.S. banks may have more exposure to commercial real estate than regulators realize because of credit lines and long-term loans they provide to real estate investment trusts, a new study finds.
Adding indirect lending to REITs increases big banks' exposure to CRE lending by about 40%, say researchers including New York University economics professor Bilal Acharya, a point they argue has been largely overlooked in discussions of the risks the troubled industry poses to lenders.
The chart below shows the additional exposure to real estate for large banks when accounting for indirect REIT lending.
The black columns represent traditional CRE loans. The pink and yellow columns represent term loans and lines of credit to REITs.
Source: Acharya, Gopal, Jaeger & Steffen, Bloomberg
Even Federal Reserve Chairman Jerome Powell has suggested the problem is “going to continue for some time.”
“We're not going to let the economy get too hot,” Powell told the U.S. Senate Banking and Housing Committee last month.
This is a risk that we have always taken on and will continue to take on for some time, possibly for many years to come.
Banks need to honestly assess what their risks are. They need to be confident that they have the capital, liquidity and systems in place to manage this risk…
The big banks can deal with this. Most smaller banks can deal with this, but it's the smaller banks that tend to have geographic concentrations in commercial real estate…
This will be an issue for many banks, but we are working on it and are very aware of it.
Again, it will be with us for a while.
Will “extension and pretense” be enough to keep the sector afloat until the Federal Reserve can save the day by lowering interest rates?
“Extending and cheating” is a real estate transaction practice in which a borrower seeks an extension to the maturity date of a loan to avoid realizing a loss.
We've seen a lot of this happen over the past year as borrowers desperately put off their problems and waited for the Fed to cut interest rates.
As you know, many fixed-rate loans created before 2022 have interest rates in the 3-5% range. When refinancing today, borrowers are looking at rates closer to 6.5-10%.
No wonder the real estate industry is anxiously awaiting lower interest rates. The key question is: Will the Fed cut rates enough, and fast enough, to prevent catastrophe?
Why the Federal Reserve's current outlook for interest rate cuts isn't enough
When it comes to refinancing commercial real estate, the Secured Overnight Financing Rate (SOFR) is very important.
The one-month SOFR is the standard index rate used for floating-rate commercial real estate loans.
As of yesterday, the one-month SOFR stood at 5.34%, as shown below in data from the Federal Reserve Bank of New York.
Source: Federal Reserve data
Currently, the forward curve (the market forecast of SOFR based on SOFR futures contracts) projects SOFR to decline significantly over the next 18 months.
In fact, one-month SOFR is expected to be 3.54% as of January 2026. This projection reflects what we have heard from the Federal Reserve about interest rate cuts over the next 18 months.
But will these lower SOFR rates save the situation?
That's impossible.
Floating rate commercial real estate loans are priced based on an index rate (such as 1-month SOFR) plus an additional spread.
Typically, the size of this spread ranges from 250 to 400 basis points.
Therefore, even if the Fed cuts rates as the market currently expects, refinancing rates are expected to be between approximately 6.04% and 7.54% by the start of 2026.
Let's go back to the chart I showed you earlier. You'll remember this huge red spike of debt coming due in 2026…
Source: Federal Reserve Data/WSJ
Now consider that many of these loans occurred during years when the one-month SOFR was effectively 0%, meaning gross interest rates were between 2.50% and 4.00%.
This means that refinancing in 2026 could cost 50% to 200% more, even after currently projected rate cuts.
Oh, and let's not forget that tenants are fleeing these buildings, resulting in lower rental income. Skyrocketing refinance rates and declining rental income are not a good combination.
Recognizing these numbers explains why a real estate analyst I read recently suggested that yesterday’s slogan, “Survive until ’25,” needs to be reworded to “Don’t retire in ’26.”
What are the action steps?
Examine your portfolio's exposure to commercial real estate.
This includes obvious exposures such as commercial REITs and regional banks, but also less obvious exposures such as private equity firms (such as Blackstone) and insurance companies (such as MetLife and Principal Financial Group).
Remember that default isn't the only risk to you as an investor: if a distressed company is forced to slash its dividend to cover its weak management, it's likely that some investors will flee, resulting in significant losses (not to mention the reduced dividend).
To avoid this scenario, pay close attention to the dividend payout ratios of the stocks you own.
It is generally believed that a dividend payout ratio between 35% and 60% means there is no risk of the dividend being cut, 60% to 75% is reasonably safe, and anything above 75% is considered risky.
Now, on the flip side, we could see some great buying opportunities over the next few quarters, but we're buying into the aggrieved real estate investors who have left this sector in the dust.
Make sure it's not you.
Have a nice evening.
Jeff Remsburg