The Risks (and Rewards) of CRE Debt

The Risks (and Rewards) of CRE Debt

Today’s commercial real estate (CRE) debt market is navigating a complex environment driven by volatile market dynamics, persistently high borrowing costs, and an imminent wave of debt maturities.

As debt servicing costs have risen in recent years, a growing number of CRE borrowers are falling behind on their payments. This issue is particularly acute in asset classes like the office segment, where market conditions have deteriorated significantly.

According to Trepp, the Commercial Mortgage-Backed Securities (CMBS) Special Servicing Rate rose by 7 basis points in July, reaching 8.30 percent—a three-year high. This increase is part of a broader trend that began in early 2024 when the rate was 6.95 percent, marking a rise of over 180 basis points since July 2023, and a significant 350 basis points higher than July 2022.

The office sector, in particular, has seen its special servicing rate surge by 46 basis points to 11.25 percent, the highest since August 2013. This reflects the broader market challenges faced by the office segment throughout 2024. Conversely, the mixed-use property sector saw a decline in its special servicing rate by 40 basis points, settling at 8.93 percent, following an 11-year high earlier in the year.

But not all sectors are struggling. Logistics, multifamily housing, and select retail assets (such as grocery anchored strip centers) continue to perform well, offering a buffer against broader market challenges.

Two property types experienced more pronounced shifts, each moving by about 40 basis points, impacting the overall rate. Most concerning, the office special servicing rate surged by 46 basis points to 11.25 percent, its highest since August 2013. This rise reflects the broader trend in 2024, with the office rate now 150 basis points above its January level of 9.74 percent. Conversely, after reaching an 11-year high in July, the mixed-use special servicing rate decreased by 40 basis points, settling back under 9.00 percent at 8.93 percent.

Economic uncertainty, while creating difficulties, also opens up new avenues for savvy investors. The ability to purchase distressed assets at lower prices, especially in sectors poised for recovery, presents a significant opportunity. Investors who can manage these turbulent times with strategic foresight may find themselves in a strong position to capitalize on market rebounds.

The looming “wall of maturities” is another critical factor in the current CRE landscape. A substantial volume of CRE debt is set to mature in 2023 and 2024, potentially exerting pressure on borrowers who need to refinance or repay these obligations. According to the Mortgage Bankers Association (MBA), the commercial real estate finance market is large and diverse, with $4.7 trillion of commercial mortgage debt outstanding. This debt is spread across various property types, lenders, markets, and borrowers, each facing unique situations. At the end of 2022, there were $660 billion of CRE loans set to mature in 2024, and by the end of 2023, this figure had grown to $930 billion. The increase was driven by loans extended through built-in options or negotiations between lenders and borrowers, often motivated by the hope that interest rates would decline.

While the increase in maturing debt may seem alarming, it’s not necessarily indicative of widespread trouble. Many borrowers have proactively addressed these upcoming maturities by securing refinancing ahead of time or negotiating more favorable terms with lenders. Furthermore, prime assets in stable markets are likely to find refinancing options more accessible, even in a tighter credit environment. However, as the MBA notes, broad brushstrokes don’t apply—each property faces its own set of challenges and opportunities, and lenders and borrowers will need to assess these on a case-by-case basis.

For investors, maintaining liquidity is crucial in this environment. Liquidity provides the flexibility needed to seize opportunities that arise from market volatility, such as the acquisition of distressed assets at discounted prices. Additionally, diversifying investments across different sectors and geographies can help mitigate potential losses, ensuring a balanced portfolio that can withstand various economic scenarios.

Investors should prioritize risk management by stress-testing portfolios against various economic scenarios and engaging early with lenders to explore options like loan extensions or restructuring, particularly when dealing with maturing debt. The Mortgage Bankers Association anticipates further extensions in 2024, driven by built-in options or negotiations. However, where extensions fall short, decisive action will be necessary.

As the commercial real estate market faces a mix of challenges and opportunities, careful management is crucial. Rising delinquencies and maturing debt pose risks but also offer potential for asset acquisition at lower prices. By maintaining liquidity, diversifying investments, and proactively managing risks, investors can benefit from today’s market and position themselves for future growth.

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