It’s just the Beginning. And it’s structural. Variable-rate CRE mortgages and much higher rates just speed up the process...
After blowing through the pandemic with no more than a squiggle, the delinquency rate of Commercial Mortgage-Backed Securities (CMBS) backed by office properties jumped to 4.5% by loan balance in June, up from 1.6% just six months ago in December 2022, according to Trepp, which tracks and analyses CMBS.
Office mortgages that had been packaged into CMBS went through a horrendous default cycle following the Financial Crisis, with the delinquency rate topping out at over 10% in 2012/2013.
But this current six-month 2.9-percentage-point spike from 1.6% to 4.5% is the fastest six-month spike in Trepp’s data going back to 2000.
So this is going to be interesting because we’re just at the beginning of a massive structural change – not a temporary blip – that is impacting office towers; turns out, companies have figured out they won’t ever need this vast amount of vacant office space.
Trepp considers a loan “delinquent” after the penalty-free 30-day grace period ends and the borrower still hasn’t caught up with the interest payment.
This delinquency rate does not include properties that are still paying interest but are past due on paying off the mortgage on maturity date. This includes the interest-only mortgages, when the whole amount is due at maturity, and mortgages with a balloon payment at maturity. As long as landlords are making interest payments, Trepp doesn’t consider the mortgages delinquent, but tracks mortgages that are past their maturity date separately.
For example, Trepp’s overall delinquency rate for all types of CMBS rose to 3.90% in June. Including the loans that were past their maturity date but were still paying interest, the delinquency rate would have risen to 4.66%.
CMBS have real advantages. They allow lenders, such as banks, to sell high-risk commercial mortgages during times of low interest rates to yield-chasing investors, such as bond funds, life insurers, etc. For banks, these mortgages might be too risky to keep on their books.
So they package them, sometimes just one big mortgage, but often several or many mortgages, into a pool of mortgages that then gets structured into different slices that investors buy, with the junk-rated slices taking the first losses in return for slightly higher yields. The top-rated slices have an A-rating or AA-rating, solidly investment grade (here’s my cheat sheet on bond credit ratings by rating agency), with the idea that the lowest rated slices will absorb any losses while the top-rated slices remain unscathed.
The mortgages – as we have seen in the current wave of defaults, including those where the landlord has just walked away from the property – are often variable-rate. Landlords liked variable-rate mortgages because they offer a lower interest rate, compared to fixed rate mortgages. And investors liked them because when rates go up, investors get a higher return, and the market value of the mortgage is largely protected.
But when rates go up a lot, as they have done since March 2022, the interest payments go up a lot, and by late last year, these interest payments began to double, and suddenly the building doesn’t pencil out anymore because rents, especially at office towers that are partially vacant, won’t cover the interest payments.
And then landlords might walk away and lose the equity. And CMBS holders end up with a defaulted mortgage and an office tower whose price at a sale will be far below the loan value. We have discussed the revenge of variable-rate office mortgages here.
And so even landlords – giant landlords such as private equity firm Blackstone and private equity firm Brookfield – have defaulted on the mortgages and then walked away from the property. They lose the equity in the property, and the lenders then have to sell the office tower for whatever they can get.
But whatever they can get for older office towers is a lot lot less than anyone had imagined a few years ago when the CMBS were issued. The losses on the mortgages for CMBS holders are huge, such as 88% and 82% by two Class-A office towers in Houston, or even a total loss, with the proceeds of the foreclosure sale just paying for fees and expenses, which happened with the vacant 46-story former One AT&T Center in downtown St. Louis. Two class-A office towers in San Francisco sold at 70% off the pre-pandemic price estimates, though they didn’t involve mortgages. Other office towers were sold with 40% to 50% in losses.
So these older office towers create some serious investor-bloodletting – but it’s thinly spread around the globe, from the bond fund in your portfolio to a pension fund in a foreign country.
And it’s structural, not a market blip; it’s an issue that will have to be dealt with over many years, such as by tearing down office towers or by converting them into residential buildings where possible.
Even lower interest rates won’t make vacant or half-vacant office towers economically viable. Markets, if allowed to do the dirty work, are good at pricing those situations, and providing a low cost-base for developers with an appetite for risk to redevelop those properties, at the expense of existing investors.