by Brandon Michaels & Chris Adnams
· An estimated $1.5 trillion of commercial real estate debt will come due by the end of 2025.
· As of Trepp’s June report, 3.90% of CMBS loans were delinquent, an 81-basis point rise in the last three months and a marked increase over the 12-month trend.
· Guidance from the Federal Reserve, Federal Deposit Insurance Corp (FDIC), Office of the Comptroller of the Currency, and National Credit Union Administration has urged lenders to provide more short-term accommodations to challenged debt, its first notable changes to accommodation guidance since 2009.
· Trepp reports an average interest rate near 4% for loans originated in 2013 and 2014. Assuming a 6.75% interest rate, a refinance yields a 14% increase in debt service and a 31% increase for loans originated in 2018 and 2019 under similar conditions.
An Overview of CRE’s Pending Debt Maturities
Owners and purchasers of commercial real estate enjoyed an extended period of low interest rates and availability of debt options over the past number of years, creating an environment of property value appreciation and demand for debt for both new purchases and refinances. A significant amount of debt originated over the past number of years, creating an environment with a significant amount of loan maturities set for the upcoming twenty-nine calendar months.
Per Trepp, a leading provider of information, analytics, and services to the structured finance, CRE, and banking markets, more than $103 billion in CMBS debt is set to mature by the end 2023. By the end of 2024, there is expected to be an additional $126 billion due, a combined $229 billion in commercial real estate debt coming due. However, these figures only account for publicly reported CMBS debt. The actual figure, including debt held privately on bank, insurance, and credit union balance sheets, among others, is likely significantly higher. In fact, it is estimated that a combined $1.5 trillion of commercial real estate debt will come due by the end of 2025.
A Willingness to Work Out
Considering these pending maturities coupled with significantly higher borrowing costs, lenders have been urged to work out debt, providing alternatives to borrowers versus handing back the keys, where possible. This guidance comes from a joint statement from the Federal Reserve, Federal Deposit Insurance Corp (FDIC), Office of the Comptroller of the Currency, and National Credit Union Administration, revealing its first notable change to regulations on commercial real estate workouts since 2009. The news also follows a successful stress test on the nation’s 23 largest banks under a hypothetical 40% drop in commercial real estate values, showing that the largest financial institutions have the capital to handle weakened fundamentals and cash flows from their commercial real estate assets in the interim.
The new guidance has already been put to the test. In a Moody’s Analytics report, of the CMBS office loans that matured in May, “36.5% were modified or extended” or roughly $750 million of debt. The policy will be further tried in the coming months as more CMBS debt is marked delinquent. As of the June report, 3.90% of CMBS loans were delinquent. While this figure is still small relative to the all-time high of 10.34% in July of 2012, it represents an 81-basis point rise in the last three months and a marked increase over the 12-month trend.
Work Out or Walk Away
It’s clear why workouts are so important to landlords. Of the debt originated over the previous ten years, it is likely that no existing fixed rate debt is at rates higher than what would be available today. Often, benchmarks like the 10-year US Treasury, 1-month SOFR, LIBOR, and WSJ Prime are used to help determine interest rates on CRE debt. Currently, the 10-year Treasury is hovering near 4%. Over the past ten years, this measure has only briefly broken the 3% mark in 2013 and 2018. Further, the Federal Funds Rate, often the basis for measures like LIBOR, SOFR, or the WSJ Prime, now stands above 5% after being pegged near 0% for the past ten years, except for a brief climb to 2.5% during 2018 and 2019.
What’s interesting is interest rates currently are not substantially above historical averages, but landlords have enjoyed a period of relatively “free money” that will ultimately have to be unwound at higher rates, which may prove problematic.
Working Out the Numbers – What Does This Mean?
Of the debt originated in 2013 and 2014, maturing in the next year assuming a 10-year term, Trepp reports an average interest rate near 4%. New debt in the market, assuming a 6.75% interest rate, would result in a 14% increase in debt service. Put another way, a loan previously qualified under a 1.30 debt service coverage ratio (DSCR), now has a lower coverage ratio of 1.14, unsatisfactory to the lender. To satisfy a refinance, rents must have increased by the same 14% or landlords will need to come up with cash to supplement a lower loan amount. The situation becomes much worse for those with shorter term maturities. Debt originated in 2018 and 2019, maturing in the next year assuming a 5-year term, under these same terms, results in a 31% increase in debt service. The same property, which five years ago handily received a loan, no longer services its debt, and now has a DSCR below 1.00.
While the new guidance from the Federal Reserve, FDIC, Office of the Comptroller of the Currency, and National Credit Union Administration will surely help give landlords time in the short run, the runway of low interest rate loan maturities on the horizon is shortening. With this low interest rate debt likely being refinanced well into 2025, it seems the only saving grace for owners of debt-encumbered properties will be a substantial reduction in interest rates. Based on Federal Reserve Chairman Jerome Powell’s remarks at the most recent Federal Open Market Committee (FOMC) meeting, a substantial reduction to interest rates in the short term appears highly unlikely, potentially creating reason for concern.