By Steven Luttman
Not all relationships are built to last. In the United States, roughly half of all marriages sadly end in divorce. While a decree marks the actual end, oftentimes discontent has been brewing long beforehand.
This is not limited to personal relationships, as business ties often experience difficult periods as well. Despite changing economic conditions, large scale foreclosure activity has so far failed to materialize. It’s starting to appear however that within the world of commercial real estate, we are within the preceding interval of unease.
Some $1.5 trillion of commercial real estate debt is set to mature before the end of 2025. Whereas residential real estate’s purpose is to provide shelter, commercial real estate is used for business or income-generating purposes. Malls, office towers and warehouses would all be classic examples. In a world of simultaneous low interest and vacancy rates, refinancing maturing debt is a non-issue. In 2023, things are very different.
Over the past 18 months, the Federal Reserve has increased their Fed Funds Rate eleven times, from an effective rate of 0.08 percent in March 2022 to today’s 5.33 percent. This in turn has caused borrowing costs to rise throughout the economy, from credit cards for people like you and me to loan rates for businesses looking to expand.
The result of this abrupt shift in monetary policy is that borrowers who originally obtained loans during the past 15 years of historically low borrowing costs are now faced with refinancing this maturing debt at levels which may turn a once profitable property into a money loser. In this case, securing new financing may not even be possible.
This is especially true when taking into account that filling these properties with tenants is becoming increasingly harder to do. For example, the continued movement towards work from home has been devastating for office buildings. According to an August report from the National Association of Realtors, office vacancy rates in the first half of the year eclipsed 13 percent nationally. In some major metros, nearly one in five office properties actively sought tenants. A drop in revenue of this magnitude makes it difficult to fund necessities such as property taxes, upkeep, insurance, and of course, the loan.
Owners being unable to meet their loan payment obligations is a growing concern. A select few office buildings in America’s largest cities made headlines recently, and not for good reasons. Marathon Asset Management is said to have acquired a six-story office building next to Penn Station in Manhattan via foreclosure auction for $16.5 million, roughly 25 percent of what the building cost to construct only a few years prior. It’s important to note that office is not the only segment experiencing hardship today. CRE data provider Trepp reported in September that delinquency rates amongst loans backed by retail buildings as well as lodging are both on the rise.
Viewing commercial mortgage-backed securities as a group, those which are 30-plus days past due have increased 50 percent year over year. Credit rating agency Fitch announced in May that they anticipate 35 percent of highly rated CMBS that is set to mature by the end of 2023 will be unable to refinance. Said in layman’s terms, “commercial real estate is melting down” -Elon Musk.
Yes, the picture painted above is unfortunate for the owners and the lenders involved, but why should the rest of us care? In the New York state, many of the services we often take for granted (local road repairs, fire departments, public schools, and law enforcement) are in large part funded by property tax collections. When property values fall, it eventually translates into lower assessments. It’s these assessments that determine property tax collection, and a shrinking pool of funds to draw from could harm the quality of these critical services in meaningful ways.
Economies are inherently in constant flux. Their movements are often described as occurring in stages, cycles, or even waves. Regardless of your preferred adjective, some points along the financial spectrum bring with them hardships.
Those who have experienced periods of turmoil in the past however know that it’s often less painful to address problems early, than it is to try and fix after they’ve already escalated.