Nearly $1.5 trillion in commercial mortgages are coming due over the next three years, according to data provider Trepp. Many of the commercial landlords on the hook for the loans are vulnerable to default in part because of the way their loans are structured.
Unlike most home loans, which get paid down each year, many commercial mortgages are known as interest-only loans. Borrowers make only interest payments during the life of the loan, with the entire principal due at the end.
Interest-only loans as a share of new commercial mortgage-backed securities issuance increased to 88% in 2021, up from 51% in 2013, according to Trepp.
Typically, owners pay off this debt by getting a new loan or selling the building. Now, steeper borrowing costs and lenders’ growing reluctance to refinance these loans are raising the likelihood that many of them won’t be paid back.
Many banks, fearful of losses and under pressure from regulators and shareholders to shore up their balance sheets, have mostly stopped issuing new loans for office buildings, brokers say. Office and some mall owners are facing falling demand for their buildings because of remote work and e-commerce. Interest rates have more than doubled for some types of commercial mortgages, analysts and property owners say.
The combination of these forces is weighing on building values, shrinking the amount owners can borrow against their properties and increasing the risk of defaults.
“What we’re seeing is the unfortunate collision of the most rapid increase in interest rates in a one-year period and the realities of how people work,” said Gregg Williams, principal receiver at Trident Pacific, a receivership firm for defaulted commercial mortgages.
Fitch Ratings recently estimated that 35% of pooled securitized commercial mortgages coming due between April and December 2023 won’t be able to refinance based on current interest rates and the properties’ incomes and values. While many malls and hotels face high default risks, the situation is particularly dire for office owners.
Xiaojing Li, managing director at data company CoStar’s risk analytics team, estimates that as much as 83% of outstanding securitized office loans won’t be able to refinance if interest rates stay at current levels.
rise in defaults could ripple through the commercial real-estate market by forcing distressed sales and pushing down property values. It could also hit regional and community banks that are heavily exposed to the sector, forcing them to write down the value of commercial mortgages on their books and set aside more cash to cover for losses.
Mortgage defaults are still rare but rising fast. The share of securitized office loans that are delinquent jumped to 4.02% in May, up from 2.77% in April and the highest level since 2018, according to data company Trepp.
Interest-only loans became more common in the middle of the past decade, said Rich Hill, head of real-estate strategy and research at investment manager Cohen & Steers. Following the Dodd-Frank Act and under pressure from regulators to cut back on risk, many banks reduced the size of the commercial mortgages they issued and shied away from riskier construction projects.
But at the same time, as a concession to borrowers, they started handing out more interest-only loans, Hill said. The share of interest-only commercial mortgages held on bank balance sheets also rose between 2013 and 2021, according to an analysis by Matthew Anderson, a managing director at Trepp, though these loans were still much less prevalent than in the commercial mortgage-backed securities market.
Interest-only loans came with lower annual payments, so property owners were able to spend less of their own cash. That boosted profits during good times.
“In a world where you think property valuations are rising, you want to use as much of someone else’s money as possible to finance your project,” Hill said.
The risk seemed minimal at the time. Interest rates were low and property values kept rising, meaning owners could expect to simply pay off the loan with a new one when the bill came due. Now, many landlords are no longer able to get new loans big enough to pay them back.
Take Centre Square, a 1.8-million-square-foot office complex in Philadelphia. In late 2019, owner Nightingale Properties took out a $368 million balloon mortgage against the property, which was later repackaged into bonds. When the mortgage came due in December 2022, Nightingale was unable to pay it off, according to Trepp data. The company overseeing the loan on behalf of bondholders has since filed a motion for foreclosure, according to Trepp data.
A Nightingale spokeswoman said the company is “working to find a solution that works for all stakeholders.”
Only some defaults end with the lender taking the keys. Often, property owners can stave off foreclosure by paying off loans with their own cash or by extending and renegotiating mortgages. Still, debt brokers and attorneys say lenders are less patient than they have been in the past.
Mark Edelstein, chair of law firm Morrison Foerster’s global real-estate group, said he is seeing more lenders take over office buildings than at any point since the early 1990s.
After the 2008 financial crisis, many banks were willing to extend troubled loans, buying owners time. Interest rates were falling, the crisis seemed temporary, and the hope was that building values would eventually recover to the point that borrowers could pay back their loans. That is exactly what happened.
This time, fewer lenders are betting on a quick recovery, at least in the office sector. Most expect remote work to be a lasting phenomenon, meaning many office towers could struggle for years to come.
“Banks don’t want to kick the can down the road anymore,” Edelstein said.