Defaults on Commercial Real Estate Loans Surge to 14-Year High

Distressed U.S. commercial real estate debt rose to a 14-year high of 5.2% in February, dogged by rising interest rates and persistent work-from-home shift, a potentially ominous sign to landlords and the banks that loaned to them.

Office properties accounted for about 44% of all defaulted commercial mortgage-backed security debt transferred in February to special servicers to work out payments, according to CMBS data firm Trepp. Debt backed by retail properties comprised 32%, and multifamily 19%.

Total distressed CMBS debt jumped to $1.84 billion from January’s $686 million. By the end of February, corporate defaults were at their highest since 2009, and seven of 23 defaults were retailers, hurt by the growing number of people who prefer to work and shop from home instead of spedning time on foot in central business districts.

“We anticipate a lot of loans to reach their maturity date and be unable to fully pay off or refinance," Trepp's Jack LaForge said in an e-mail. "In order for special servicing rates to go down, lending conditions would have to soften a lot, and interest rates will have to go down for this to be possible.”

As commercial real estate struggles to recover from the pandemic, rising defaults threaten to ripple through the broader economy, as the banking industry confronts loans they made to landlords that are now worth far less than at the time of the transaction. That could force lenders to sell properties at fire-sale prices, even as the Federal Reserve hikes interest rates, raising the cost of refinancing for real estate borrowers.

A `Spoiled' Industry

“The industry got spoiled with a decade of ridiculously low interest rates, leading to high valuations," commercial real estate lawyer Joshua Stein said in an e-mail. "When rates rise, valuations drop."

That's not all, Stein said. Unlike during the 2008-2009 financial crisis, when lenders waited for borrowers to repay, "My sense is lenders won’t have the same patience this time. That’s just my instinct. I do know that the foreclosure lawyers are pretty busy right now, and they expect to be busier."

Some of the biggest commercial landlords in the country include Trammell Crow, Tishman Speyer, SL Green and Hines.

San Francisco, Washington and New York have had a sustained increase in the share of criticized loans, Trepp said, referring to loans by banks as having an elevated risk of default.

The Bottom Line

The increase in defaults on commercial real estate loans, particularly office buildings, may seem reminiscent of 2008, when the housing bubble burst. That could be good news for big investors who could gobble up properties at bargain prices.

“They’re waiting for a lot of these buildings to go back to the banks,” said Ruth Colp-Haber, chief executive officer of brokerage firm Wharton Property Advisors. The banks “will then presumably have to sell them quickly at a very low price compared to where they’re on the books now.”

Clarification—April 4, 2023: Attributed comments from Trepp to the analyst instead of the spokesperson.