A new paper from four economists at the National Bureau of Economic Research argues that 14 percent of the $2.7 trillion commercial real estate loan market — and 44 percent of office loans — currently carry outstanding loan balances higher than property values and are at risk of immediate default.
The paper also calculated that a 10 percent default rate on all CRE loans could trigger up to $80 billion in bank losses and dozens of potential bank failures. On the brighter side, however, the authors argued interest rate declines engineered by the Federal Reserve could stave off further distress.
Authored by Erica Xuewei Jiang of the University of Southern California, Gregor Matvos of Northwestern University, Tomasz Piskorski of Columbia, and Amit Seru of Stanford, the economic study analyzed 35,253 outstanding loans totaling $825 billion in aggregate value from the December 2023 CMBS market using data from DRBS Morningstar.
The economists found that while the average CRE loan was underwritten at a 61 percent loan-to-value (LTV) ratio, 29 percent of outstanding CRE loans — and 56 percent of office loans — currently hold LTVs higher than 80 percent. That means the property value behind the loan has declined from the underwritten value by at least 19 percent, thus creating likely refinancing challenges in the event of further property value declines.
Even more concerning, the economists found that 14.3 percent of all loans, and 44.6 percent of office loans, presently exceed the current property value underlying the loan, meaning the LTV exceeds 100 percent and the loans are at risk of imminent default.
“We tried to assess how big the issue of CRE distress is, so we quantified how many loans are underwater, and because of the decline in property values, the outstanding debt is more than current value,” Piskorski told CO. “I’d say that 14 percent [of loans in negative equity] is a reasonable number, and that doesn’t mean all loans will necessarily default, but there will be potential workouts and it very much depends on the interest rates path.”
The economists also studied the debt service coverage ratios (DSCR) to further quantify the current health of the CRE loan universe.
The study found that lenders originated the average CRE loan at a 3.97 percent interest rate, but today an average refinancing rate would rise to 6.71 percent. (For office loans, the average rate jumps 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 approximately 6.4 percent of all CRE loans (and 6.6 percent of office loans) have DSCR less than 1, indicating that cash flow cannot support underwritten debt service.
If these same loans were asked to refinance today at the current interest rate of 6.71 percent, a whopping 17.2 percent of all CRE loans (and 24.3 percent of all office loans) would not be able to pay their obligations, as their DSCR would be less than 1.
“The DSCR situation is very important, so we look at how many loans there are where net cash flow can’t cover the loan balance, and we see what happens if they have to refinance to current rates,” explained Piskorski. “A good chunk comes to maturity in the next few years, and if rates remain elevated, of course, the cash flow situation will deteriorate.”
Commercial banks are the most at risk when it comes to impending maturity defaults.
Commercial real estate loans account for $2.7 billion in U.S. bank assets in the aggregate, according to the report. A 10 percent industry-wide default rate of CRE loans would cause roughly $80 billion in commercial bank losses; a 20 percent industry-wide default rate of CRE loans would lead to $160 billion in bank losses.
“While the above losses due to CRE distress are an order of magnitude smaller than the $2 trillion decline in bank asset values associated with higher interest rates, they would increase the insolvency risk on a substantial set of U.S. banks,” according to the report. “We find that additional 231 banks with aggregate assets of $1 trillion would have their marked-to-market value of assets below the face value of all their non-equity liabilities.”
If there’s a silver lining to this, it’s the recent pause in interest rates engineered by the Federal Reserve. Federal Reserve Chairman Jerome Powell announced on Dec. 13 that interest rates would remain steady through the end of the year and that the central bank is forecasting three rate cuts in 2024.
“Certainly, if the interest rates continue to go down this would — all else being equal — help increase property prices and that will make refinancing much easier,” said Piskorski. “The Fed lowering interest rates will help in two ways: It helps property values go up and will make refinance loans at maturity much easier.”
But Powell can control only so much. Piskorski emphasized that it is the 10-year Treasury yield, which is less well understood than the Federal Reserve federal funds rate, which sets the borrowing costs for commercial real estate loans. The 10-Year Treasury yield currently sits at 3.94 percent, down from a high of 5 percent on Oct. 19, and is influenced by bond markets as much as it is impacted by Federal Funds Rate behavior.
“There is already a meaningful 20 percent decline in the benchmark rate based on where CRE loans are made, but that’s not enough,” said Piskorski. “By our analysis, you’d need to have a decline of 100 to 150 basis points on the 10-Year Treasury in the next year to decelerate these issues.”
An acceleration in defaults might be hard to stop now that that ball is rolling down the hill.
The delinquency rate on all commercial mortgages sits at 4.58 percent, but office loan delinquencies have risen from 1.58 percent in December 2022 to 6.08 percent in November 2023, according to the report.
“We think people are overly optimistic,” said Piskorski. “The 10-Year Treasury is still around 4 percent. You see defaults are going up. We’re seeing it in the data already.”
Brian Pascus can be reached at [email protected]
