CONTRIBUTORS
Richard Byrne
President,
Benefit Street Partners
Commercial real estate (CRE) debt is navigating a challenging environment, impacted by steeply rising interest rates, falling property valuations, and severe issues in the office sector. This situation is exacerbated by a looming maturity wall of low-interest loans due to refinance in late 2024 and 2025, potentially causing significant distress for both borrowers and highly leveraged lenders.
When the levee breaks—The maturity wall
There is a wall of transitional real estate debt set to mature over the next two years (Exhibit 1). Data firm Trepp estimates that $1.2 trillion in CRE loans will reach maturity in 2024-25, with nearly another $1.8 trillion to follow in 2026-2028.
Exhibit 1. Wall of Maturities
Source: Trepp, Q4 2023. *Other: Primarily comprised of multifamily lending by Fannie Mae and Freddie Mac. This could also include finance companies (private debt funds, REITs, CLOs, etc.), pension funds, government or other sources.
Much of this debt was financed in 2021 after COVID, and at very low interest rates (2021 was one of the most prolific origination periods in recent history). A large portion of these loans were financed by banks—and to the office sector. When these loans come due many will be distressed. Borrowers will be unable to service the debt at the higher base rates. Lenders will come under pressure as defaults mount.
Maturity dates are the day of reckoning. When interest rates were consistently trending lower, as they were for 40-plus years, most borrowers simply refinanced—often with a better rate and longer term. Today, because financing costs have doubled or tripled since 2021 (a phenomenon that generally hasn’t been seen since the 1970s), this will be unlikely. Most properties have declined in value. Owners will be hard pressed to find originators willing to lend.
The lenders embargo
Given the maturity wall, most industry lenders—regional banks, mREITS, and private debt providers—are no longer offering capital. This is a major headwind for CRE. The loan market has ground to a halt. In the same way that rising interest rates pressure borrowers, lenders are also feeling the squeeze. The relationship between CRE lending and rates is paradoxical. It is a double-edged sword. While higher base rates provide lenders higher income initially, they simultaneously weaken borrowers. When loans reach maturity, it may be difficult for many borrowers to pay back the debt. This obviously hurts lenders, resulting in more defaults, write-downs, and losses.
Adding insult to injury, many mid-market lenders have high levels of exposure to the very challenged office sector. Consider the regional banking industry. Nearly 70% of all outstanding middle market CRE debt is held at small and regional banks (Exhibit 2). Roughly 30% of their books are loans to office.
Exhibit 2. Regional Banks Account for Majority of Outstanding CRE Debt
Source: Federal Reserve H.8 reported U.S. bank CRE holdings. Data is non-seasonally adjusted and as of October 29, 2023.
When these and other sector loans mature the banks will face significant balance sheet challenges. Given the Fed’s tightening—coupled with secular trends—everything is worth much less than it was two years ago. In addition, banks must navigate increased capital reserve requirements. The bottom line, banks are not lending because they need to hoard cash. They need to prepare to defend against a wall of potentially broken loans. They are trying to guide to safety bricks falling from the sky.
Opportunity for lenders with dry powder
Two of the most active lenders in the market, regional banks and mREITs, are currently on the sideline. They are saving cash to prepare for the worst as they hope for the best. Direct lenders, apart from a handful of well positioned players, find themselves in similar predicaments in terms of legacy loan issues, handicapped by rising rate issues and office exposure. Probably the last thing many are thinking about is playing offense; they are conserving as much cash as possible.
In contrast, managers with dry powder and limited office exposure on their books are in a great position. They will benefit from a vast and fertile lending landscape, empty of competitors like banks and mREITs. They can be selective in lending to high-quality properties that have already been discounted 20-25%. They can write preferable terms and set higher rates. Good lenders with ample liquidity—and without bad exposures—should thrive.
WHAT ARE THE RISKS?
Past performance does not guarantee future results. All investments involve risks, including possible loss of principal.
Risks of investing in real estate investments include but are not limited to fluctuations in lease occupancy rates and operating expenses, variations in rental schedules, which in turn may be adversely affected by local, state, national or international economic conditions. Such conditions may be impacted by the supply and demand for real estate properties, zoning laws, rent control laws, real property taxes, the availability and costs of financing, and environmental laws. Furthermore, investments in real estate are also impacted by market disruptions caused by regional concerns, political upheaval, sovereign debt crises, and uninsured losses (generally from catastrophic events such as earthquakes, floods and wars). Investments in real estate related securities, such as asset-backed or mortgage-backed securities are subject to prepayment and extension risks.
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