'No one is throwing good money after bad.' Why 2024 looks like trouble for commercial real estate.

By Joy Wiltermuth

Property owners pocketed billions of dollars by refinancing properties when rates were low. They aren't going to throw it away now.

First goes the easy money, then come the defaults, especially when property owners have already cashed out.

Investors are bracing for 2024 to be pretty gloomy in the U.S. commercial real-estate market, with more landlords expected to throw in the towel on downtrodden buildings with debt coming due.

Higher interest rates and wobbling property values continue to be a source of angst, even though benchmark borrowing rates since the fall have come down sharply. A crucial sign to watch will be how much equity borrowers still have left in the buildings they own.

For years, owners of commercial real estate have pocketed billions of dollars by refinancing properties at skyrocketing values when debt was dirt cheap. As valuations come down, the debt attached to those properties is increasingly more than what the buildings are worth. The owners aren't expected to throw the money they have taken off the table down a sink hole now.

"In my mind, if you have anyone significantly underwater they may just want to hand the keys back," said Gabe Rivera, co-head of securitized products at PGIM Fixed Income, a division of PGIM, the $1.2 trillion asset management business of Prudential Financial Inc. (PRU)

"No one is throwing good money after bad."

Rising default risks

Regulators in December said the near $6 trillion pile of outstanding commercial real-estate loans, of which about half were owned by banks, was a top threat to the financial system in 2024.

Loan delinquencies and defaults, while still well below past crisis peaks, have been picking up in recent months as more borrowers struggle to modify, pay off or refinance maturing debt.

The nation's biggest landlords frequently turned to Wall Street's commercial mortgage-backed securities market in the past decade for loans as large as $1 billion, or to finance portfolios of properties, often on a non-recourse basis.

'In my mind, if you have anyone significantly underwater they may just want to hand the keys back.' Gabe Rivera, co-head of securitized products at PGIM Fixed Income

Blackstone Inc. (BX), Brookfield Properties( CA:BN) and Columbia Property Trust, which is controlled by Pimco funds, made headlines in 2023 as part of an early wave of defaults, or write downs in this cycle.

CMBS loans are popular because they typically shield an owner's personal wealth and other properties in the event of a default, making it easier to walk away. During market upswings, these loans often also include borrower "cash outs."

When borrowers cash out, the funds often are treated like equity by property owners. It can be used to fund building upgrades or to buy other assets, with few strings attached.

"It is definitely a topic that's very relevant," said Greg Handler, head of mortgage and consumer credit at Western Asset Management Company, a fixed-income manager with $369.5 billion in assets under management.

"If they already cashed out," Handler said, it reduces the likelihood that a borrower will stick by a property, or put equity in to refinance maturing debt.

Blackstone, in a statement to MarketWatch, said it aims to invest in sectors with strong fundamentals that benefit from macro demand trends, "which is why the majority of the real estate we own is in sectors like logistics, student housing and data centers and why less than 2% of our owned portfolio is traditional U.S. office."

Pimco and Brookfield didn't immediately respond.

'The money was there'

Cash outs proliferated in the run-up to the 2007-2008 global financial crisis, and again as credit markets roared back to life in the era of cheap debt that follow.

"When you had the cash outs, interest rates were so low, and every bank and nonbank lender was willing to make loans," said Justin Newman, partner at law firm Thompson Coburn. "Everybody cashed out, because the money was there and you're not going to turn it down."

Specifically, borrowers pulled about $141.5 billion in cash out of U.S. commercial properties financed by Wall Street's CMBS market over roughly the past 20 years, while adding about $50 billion back, according to a DBRS Morningstar tally compiled for MarketWatch.

That translates to about $93.5 billion in net cash extracted, with the bulk taken out in the past 10 years of low rates, according to the data.

The CMBS market, though only a 6% to 25% slice of the lending pie in recent years, serves as a barometer for trends in the broader commercial real-estate industry.

Unlike banks and other lenders that typically keep loans on their books, the CMBS market packages its mortgages into bond deals that are sold to investors, distributing the risk across state lines and throughout the financial system.

On the other hand, the market also provides loan-level financing details that other lenders won't often disclose. Bond investors also receive monthly performance updates at the property level, which can show the first signs of stress.

Distress ahead

Pressure on commercial real estate began building in 2023 as a first wave of property loans matured during the Federal Reserve's rate-hiking cycle, and financial cores of many big cities saw only a reluctant return of workers to offices after the pandemic.

The Fed may now be done hiking rates, and more companies requiring more days in the office, but borrowing costs are still expected to stay well above pandemic lows, keeping pressure on property values, market participants said.

Interest rates, pegged at 6.5% for commercial property loans in late December have eased back from above 7% this fall, but remain well above the pandemic lows of under 4%. The yield on the 10-year U.S. Treasury bond BX:TMUBMUSD10Y recently sunk to 3.87%, but remains much higher than the 1.4% range of two years ago.

That doesn't bode well as an estimated $1.2 trillion of commercial mortgage debt is set to mature through 2025, according to data from the Mortgage Bankers Association.

Moody's Investors Service in December said that roughly one-fifth of the $42.3 billion of CMBS loans it rates that are due to mature next year could be at an elevated default risk, with office loans a particular worry.

Some maturing loans will be extended by lenders, while others borrowers could find relief from the estimated $135.5 billion pile of "dry powder" amassed globally through December by private equity firms for real estate opportunities, according to Preqin data.

"My view is that this is going to be a slow bleed, a situation where keys are coming back to lenders, regional banks are selling assets and pension plans are exiting," said Seth Meyer, head of fixed-income strategy and a portfolio manager at Janus Henderson Investors, which has $308.3 billion in assets under management.

"This will create opportunities," Meyer said. "This is where it will be a credit-picker's market for a while."

-Joy Wiltermuth

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12-30-23 1138ET

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