In this episode of “The Inside Look,” Senior Commercial Real Estate Economist Xander Snyder discusses the two main categories of distress — liquidity shortages and bankruptcies — and their unique impacts.
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Transcript:
Hello, I'm Zander Snyder and this is First American's Inside Look.
Commercial real estate is a credit-intensive business, which means that debt is a significant factor in acquiring commercial property. Interest rates, the cost of debt, affect commercial real estate in two main ways. First, higher interest rates make a building less profitable because, all else being equal, more money has to be spent on interest expenses. Second, higher interest rates can affect property prices by reducing the amount of money buyers can borrow. So, with higher interest rates, buyers can't afford to pay as much for a building because they have less money to borrow.
With interest rates now significantly higher than they were before the pandemic, there's a lot of attention on commercial real estate distress. But not all distresses are the same. In fact, there are two main categories of distress: liquidity shortages and bankruptcy, each with their own unique considerations and impacts. When these occur together, buildings are at the highest risk of facing foreclosure.
Let's start by looking at liquidity deficiencies. Liquidity deficiencies occur when a building doesn't generate enough income to cover expenses. This is arguably the more immediate of the two types of crisis because if nothing is done to increase the property's cash flow, the property owner could run out of cash. A liquidity deficiency means time is running out, and something needs to be done relatively quickly to fix the building's operations.
The second type of problem, bankruptcy, occurs when the value of the property falls below the mortgage balance. Colloquially, this is often referred to as being underwater. There is a deadline to resolve the bankruptcy issue, but that deadline is usually a bit longer and is determined by the mortgage maturity date. As long as the property can generate enough income to cover day-to-day expenses, the owner can wait for the price to recover, hopefully before the mortgage comes due.
Insolvency quickly becomes a problem if the owner is unable to fully refinance the outstanding balance of the mortgage at the maturity date, or if the cost of the new mortgage, or the interest rate on the new mortgage, creates a liquidity shortage after refinancing. So when people talk about this looming maturity wall for commercial real estate mortgages, they are usually referring to this insolvency problem. But liquidity shortages and insolvency pose unique challenges for owner-operators. Triggers for each are necessary but not sufficient by themselves to force foreclosure, and it's worth keeping this distinction in mind.
Currently, the fundamentals of different asset classes are very different, and so are their respective liquidity risks. Given the decline in demand for office space and the increase in remote working due to the pandemic, the riskiest asset class right now is office from a liquidity perspective. According to Trepp data, roughly 11% of office loans are illiquid and unable to fully cover the cost of their mortgages, the highest percentage of any asset class.
Bankruptcies in office properties are also a risk right now, but so are other asset classes. According to a recent research report from the National Bureau of Economic Research, about 14% of commercial mortgages are below their collateral value, while about half of office mortgages are currently below their collateral value.
As more mortgages come due (about $930 billion worth of commercial real estate mortgages are coming due this year alone), the risk of bankruptcy becomes more imminent, especially for properties that have declined or are likely to decline in value.
I will be in Phoenix in mid-May to discuss the current state of the commercial real estate economy and how long this commercial real estate reset is likely to last. If you're interested in attending, please reach out to your local First American representative.
Thank you for joining us for this episode of The Inside Look, and we'll see you next time!