John F. Fish’s opinion piece on MarketWatch paints a pretty gloomy picture for commercial real estate over the next several years with massive defaults possible. He indicates that nearly $1.5 trillion dollars in commercial real estate loans will be maturing within the next two years, which could make refinancing those assets tricky, resulting in a lot of loans going bad.

Since March of 2022 the Federal Reserve has aggressively hiked rates to tame inflation, which puts significant stress on the real estate market generally. The current Prime rate sits at 8.25%. We have to go back to June 29th, 2006 to see the Prime rate at that level and a lot has happened in the last 17 years, which makes that sounds like ancient history. It goes without saying that most of the loans maturing in the next two years will be looking at a very different interest rate environment compared with when the loans were originated.

So, How Big is the CRE Market?

According to the Mortgage Bankers Association, as of March 10, 2023 there are a total of $4.5 trillion of CRE loans in the United States, so nearly a 1/3 of those will mature in the next 21 months. Below is a chart from the Mortgage Bankers Association detailing the relative percentage loan exposure by each type of lender and property type.

At March 10, 2023. Source: Mortgage Bankers Association, Cohen & Steers.

What Does This Mean?

Assuming most of these properties were financed between 2013-2019 the prime rate was between 3.25%-4.75%. This has two primary impacts to properties with maturing notes. The first is that interest rates are up 50% to 100%, which increases the cost of that portion of the capital. The second is that high interest rate environments put upward pressure on cap rates.

For a slightly rosy example, let’s say you purchased an office property for $10,000,000 on a 6.0% cap rate ($600,000 Net Operating Income) in 2019. You put down 35% and borrowed $6,500,000 (65% loan to value) at 4.75% on a 25 year amortization the annual debt service payment is $445,000, resulting in cash flow of $155,000 and debt service coverage ratio of 1.34x.

Now in 2024 your loan matures and you still owe $5,700,000, but the new rate on debt is 8.00%. The cap rate has moved up and office has seen vacancies pick up during this time, so you might even have a lower Net Operating Income. Assuming the property managed to stay leased up and had 5% rent growth, which is not the case in a lot of major downtowns, you now have an NOI that is $630,000. At a cap rate of 7.75% the new value is $8,150,000, resulting in a loan to value of 70%. Assuming you’re able to get a 25 year amortization again, which the incumbent lender is unlikely to provide because you’ve already burned 5 years into the original 25 year amortization, the new annual debt service is $528,000, $102,000 of cash flow and 1.19x DSCR. The lender in this situation will probably require the loan to be paid down to a 65% LTV or require some additional personal recourse, which, altogether, this is not a bad outcome if the owner has personal capacity and patient equity, but that is not always the case. This scenario gets very bad, very quickly for properties that have vacancies icrease, a lot of lease maturities in the next 24 months, and have a higher level of leverage. Workable financing might not be easy to come by in those situations.

Now the question is will we have a wave of deals going bad and being foreclosed on or will owners be able to work through these issues? I suspect we’ll see a lot of challenges in the office sector with relatively fewer issues in the multifamily and retail spaces, but there will be some fallout. Regardless this will present a potential windfall opportunity for well capitalized buyers that are willing to go heavy on equity and have equity with a longer time horizon. Some fortunes will be made and others lost in the next couple of years.