A new paper by four economists at the National Bureau of Economic Research argues that 14% of the $2.7 trillion commercial real estate loan market and 44% of office loans currently have outstanding loan balances that exceed property values and are at risk of immediate default.
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The paper estimates that a 10% default rate on all CRE loans could cost banks up to $80 billion and lead to dozens of bank failures, but on the bright side, the authors argue that lower interest rates engineered by the Federal Reserve could avert a further crisis.
The economic study, written by Erica Xuewei Jiang of the University of Southern California, Gregor Matvos of Northwestern University, Tomasz Piskorski of Columbia University and Amit Sell of Stanford University, used data from DRBS Morningstar to analyze 35,253 outstanding loans totaling $825 billion in the December 2023 CMBS market.
The economists found that while the average CRE loan is underwritten at a loan-to-value ratio (LTV) of 61%, 29% of outstanding CRE loans and 56% of office loans currently have LTVs above 80%. This means that the property values backing the loans have fallen by at least 19% from their underwriting values, making refinancing likely to be difficult if property values fall further.
Even more concerning, the economists found that 14.3% of all loans and 44.6% of office loans currently have LTV ratios that exceed the current value of the real estate backing the loans, meaning they are over 100%, putting the loans at imminent risk of default.
“As we tried to assess how big the CRE crisis is, we quantified how many loans are underwater, and the outstanding debt is greater than the current value due to declining real estate values,” Piskorski told CO. “Fourteen percent is [of loans in negative equity] “This is a reasonable figure and does not necessarily mean that all loans will default, but potential defaults are possible and are highly dependent on interest rate movements.”
The economists also studied debt service coverage ratios (DSCRs) to further quantify the current health of CRE loans overall.
Research shows that lenders funded the average CRE loan at an interest rate of 3.97 percent, but today the average refinance rate would rise to 6.71 percent (for office loans, the average rate would jump to 7.42 percent). And while the average CRE loan was underwritten to achieve a healthy DSCR of 2.3 (2.7 for the average office loan), today roughly 6.4 percent of all CRE loans (and 6.6 percent of office loans) have a DSCR below 1, indicating that their cash flows cannot support repaying the debt they have assumed.
If these same loans were asked to refinance at the current interest rate of 6.71 percent, their DSCR would be less than 1, meaning 17.2 percent of all CRE loans (and 24.3 percent of all office loans) would be unable to service their debt.
“The DSCR situation is very important, so we're looking at how many loans we have where the net cash flow doesn't cover the loan balance and what would happen if we were forced to refinance at current interest rates,” Piskorski explained. “A significant portion matures over the next few years, and if interest rates remain high, that would naturally worsen the cash flow situation.”
When it comes to imminent default on maturities, commercial banks are at greatest risk.
According to the report, commercial real estate loans account for $2.7 billion of total bank assets in the U.S. If the industry-wide default rate for CRE loans were 10%, commercial banks would lose roughly $80 billion. If the industry-wide default rate for CRE loans were 20%, banks would lose $160 billion.
“While these losses from CRE failures are orders of magnitude smaller than the $2 trillion decline in the value of bank assets that would result from rising interest rates, the risk of failure for a significant number of U.S. banks would increase,” the report said. “For 231 banks with total assets of $1 trillion, the marked-to-market value of their assets would fall below the par value of all non-equity liabilities.”
If there's a silver lining to this, it's the Federal Reserve's recent pause on interest rates. Fed Chairman Jerome Powell announced on Dec. 13 that interest rates will remain stable through the end of the year and that the central bank expects to cut rates three times in 2024.
“Certainly, if interest rates continue to fall, all else being equal, that will encourage real estate values to rise and make refinancing a lot easier,” Piskorski said. “The Fed's rate cuts will help in two ways: They will encourage real estate values to rise and make it a lot easier to refinance loans as they mature.”
But Powell has only limited control. Piskorski stressed that it is the less understood 10-year Treasury yield, rather than the Fed's federal-funds rate, that determines the cost of borrowing for commercial real estate loans. The 10-year Treasury yield, now at 3.94%, is down from a high of 5% on Oct. 19 and is as influenced by the bond market as it is by movements in the fed-funds rate.
“While geographically-based benchmark interest rates for CRE loans have already fallen by 20%, that's not enough,” Piskorski said. “Our analysis suggests that 10-year Treasury rates would need to fall by 100 to 150 basis points over the next 12 months to mitigate these issues.”
Now that the ball has started rolling down hill, it may be hard to stop the default acceleration.
The overall delinquency rate for commercial mortgages is 4.58%, but the delinquency rate for office loans has increased from 1.58% in December 2022 to 6.08% in November 2023, according to the report.
“I think people are overly optimistic,” Piskorski said. “The 10-year Treasury yield is still around 4%. Defaults are rising. You can already see it in the data.”
Brian Pascus can be reached at bpascus@commercialobserver.com