State Of Commercial Real Estate: Sharp Spike In Office Delinquency Rates Coming
Following our March 9 note on the Big Short 3.0 (see "Why Small Banks Are In Big Trouble: As Hedge Funds Pile Into The New "Big Short", The Next 'Credit Event' Emerges"), and with the recent stress in the banking sector, sentiment in US commercial real estate (CRE) - and especially the office sector - has turned apocalyptic as investors are concerned about potential spillover effects (with both JPM and Morgan Stanley recently joining in the gloom parade), especially as high-profile defaults continue to make headlines as borrowers face higher debt service costs, refinancing gets tougher ahead of $400BN in CRE debt maturities this year alone...
... and hedging needs are escalating; delinquency rates across property types, particularly office, are rising; and the lending environment is likely to get tougher ahead given the active role of regional banks in CRE over the past couple of years.
And so, three weeks after we first explained the toxic feedback loop between CRE and small banks, last week, Goldman also joined the fray and published a report on the State of the CRE market (available to pro subs here), where the bank looked at headline defaults, commercial mortgages by lender groups including the role of regional banks, and DQ rates across property types. Then over the weekend, the bank has published the second part of its lengthy CRE assessment, in which it discusses:
- Total size of mortgages: Assessing the total size of the commercial real estate debt market, and present the breakdown between different lender groups and property types. Also a break down for regional banks and national banks.
- Near-term maturities: A look at near-term maturities in CRE, including the breakdown between different asset classes and lender groups.
- Geography of regional banks: For banks — regional and national — a look at their geographic and asset class exposure within CRE lending.
- DQ rates and their path: A look at office DQ rates today, compared against the path to peak delinquency witnessed during the GFC.
- Headline-makers on property defaults: An update on recent headlines across property defaults.
Below we excerpt from the full report (which again is available to professional subscribers in the usual place).
Sizing the US CRE mortgage market
There are over $5.6 trillion of outstanding commercial/multifamily mortgages in the US. Within this amount, at the end of 2022, the Federal Reserve Board’s Flow of Funds Accounts data attributed $2.8 trillion to banks and thrifts. That said, this $2.8 trillion includes $627 bn of loans collateralized by owner-occupied commercial properties and another $468 bn of loans backed by acquisition, development and construction projects (including single-family development). Excluding these amounts, there are $4.5 trillion of outstanding commercial/multifamily mortgages in the US, and banks account for ~40% of this overall, at $1.7 trillion, as shown in Exhibit 1.
Looking into the share of regional banks within bank lending, regional banks account for 65% of CRE national bank lending (national banks + regional banks); note that according to FDIC, small and medium-sized banks (<$250bn in total assets) account for ~80% of total commercial real estate lending. It is worth noting that there are differences in definitions between the two. For example, FITB is a national bank, but it’s asset base is $120bn (so <$250bn), meanwhile, PNC is a regional bank with its asset base >$250bn. For the office segment, within US Banks, regional and local banks account for 62% of lending, while national banks comprise the remaining 38% (Exhibit 3).
Near-term maturities in US CRE mortgages
In 2023-24, about $1.1 trillion of debt is maturing, comprising 32% held by banks, and 25% held by CMBS. Looking at this $1.1 trillion debt maturity by property type, office loans account for 23% of this debt, while multifamily accounts for 31%, followed by another ~10% each for industrial, retail and hotels.
Geography of loans exposure for Regional Banks
In recent years, office markets in core urban gateway cities have come under pressure as office occupancy levels are well below the pre-pandemic levels. With this dynamic at play, one increasing question we receive from investors since we published our State of CRE report has focused on the geographic exposure of office loans for regional banks, particularly in cities like NY, LA, SFO and Seattle. Overall, looking at bank lending, according to the Goldman banks analyst, 25% of their loan mix sits in commercial real estate.
Office debt market — 2022
On the west coast, regional banks were more active in office loan origination in 2022 compared to national banks. Within office, LA, Seattle, No NJ, Chicago, Las Vegas were standout markets —some of these markets have obviously been in the headlines as far as office headwinds are concerned.
Multifamily debt market — 2022
Within multifamily, regional banks were very active in coastal markets in 2022, particularly in and around NYC, LA and Boston. Meanwhile, investor-led debt was extremely active in the sunbelt markets within the multifamily space.
Total CRE debt market — 2022
Across the US, banks comprised over 40% of the debt market in 2022. Overall, across different property types within CRE, regional banks were aggressive, particularly in markets like LA, NYC Boroughs, No NJ, Boston and Chicago. Meanwhile, investor-led debt was more active in the sunbelt markets.
Office DQ rates and their path
CMBS delinquency rates in the office segment have started to tick up, but are well below GFC levels. Looking forward, Goldman expects CMBS delinquency rates in the office segment to increase "meaningfully." Here Goldman also notes that the most recurring question it has received from investors pertained to the level of DQ rates that can be expected in this cycle, especially as it took office delinquency rate four years to peak during the GFC. While the unemployment rate — a key driver of higher office DQ rates during the GFC — is much more benign (at least at the moment), Goldman thinks the rate of increase in this cycle would be more pronounced given:
- The trajectory of interest rates in the current cycle, given the sharp increase in recent quarters, vs interest rates that were generally moving lower between 2008 and 2012.
- Structural headwinds associated with the office asset class, especially for Class B and Class C. According to CoStar, current total US office inventory is tracking at 8.4bn sqft, with the mix of Class A, B and C at 38%, 44% and 18% respectively. According to CWK, ~1.4 billion square feet of office will be considered obsolete by 2030 — this indicates a large inventory downsize in Class B/C assets.
Headline-makers on property defaults
Finally, here is an update on recent headlines across property defaults that show that even high profile institutions and Class A assets are experiencing difficulties in refinancing, with challenges more pronounced in the office sub-sector given the presence of structural headwinds.
More in the must-read full Goldman notes (part 1 and part 2) available to pro subs here.
