This year, hundreds of large US office buildings will be unable to refinance their debts due to the current interest rate.
According to the Mortgage Bankers Association, there are $117bn in commercial loans that are tied to offices and will need to be paid back or refinanced by 2024.
Many of these were taken out in an earlier time when interest rates had been lower. Since then, the commercial mortgage rates nearly doubled while the performance of many building has plummeted, threatening investors with billions of dollar losses.
John Duncan, the head of Polsinelli’s real estate finance department, said that it would be difficult to complete some refinancings. We’re seeing deals in which even sophisticated borrowers have called it quits and asked their lenders if they wanted to take the keys.
Commercial mortgages, unlike US home loans are almost exclusively interest-only. Developers of large properties have lower monthly payments but have to pay a balloon payment that is equal to the loan amount when the mortgage is due.
Losses are expected to be much lower than they were during the housing crisis of 2008. Sour loans can cause investors to lose billions of dollars, ruin some property developers (such as Austrian property owner Signa) and force forced sales on an already struggling office market. Signa’s administrator sold the company’s half ownership in New York’s Chrysler Building in December to raise cash.
Richard Hill, head of real-estate strategy at Cohen & Steers, said: “We’re just beginning to try and weather the downturn in the office market.” This isn’t driven by fundamentals, but rather the rising cost of financing.
Investors have been lowering their expectations for interest rates since November began, when they feared that inflation would be higher than expected. They also feared the US Federal Reserve’s policy of “higher forever” and that it might adopt this approach. This has given some office owners a small ray of hope.
While investors wait for rates to drop again by the Fed, refinancings continue. After months of negotiation, Aby Rosen, a developer from New York, secured a deal last month for the iconic Seagram Building, located 10 blocks north of Grand Central Station, set back on Park Avenue. This was after the $760mn mortgage debt had been extended.
Banks hold about two thirds of all the mortgages that are due soon. Delinquencies for these loans, which are usually backed by better-quality or less-leveraged properties, are on the rise but still very low. The Federal Deposit Insurance Corporation data shows that it was only 1.5 percent at the end the third quarter.
Losses on these loans may be substantial despite the low default rate. In December, US economists discovered that 40% of the office loans listed on bank balance sheet were underwater, which could cause problems for dozens regional banks who hold them.
Leo Huang is the head of commercial property at Ellington Management. He said, “People should realize that regional banks are still exposed to commercial real estate troubles.”
Commercial mortgaged backed security (CMBS) is used to fund the rest of the office property loans that are due to expire. This type of bond pays more than corporate bonds or government debt and is held by pension funds, insurance companies and individual investors.
CMBS now totals about $800bn. According to Trepp, the delinquencies of office loans financed with CMBS topped six per cent by the end November. This is up from 1.7 percent a year ago.
Huang said that the CMBS market had done a great job at spreading out risk. But that also means that there will be some pain.
Moody’s Analytics predicts that 224 of the 605 properties with mortgages due to expire soon will face difficulty refinancing in this year. This is either because they have too much debt, or their rental performance has been poor.
One of the buildings on this list is the former Sears Tower, which was the tallest building for over two decades following its completion in 1975.
The building, now known as Willis Tower owes $1.3bn secured debt due in March. Recent annual income, before interest payments, was 7 percent of the debt. Moody’s says that owners of buildings who do not generate at least 9% of their debt as annual income, will find it difficult to refinance this year, due to higher interest rates.
The Covid-19 pandemic, and the increase in office vacancies that resulted from it, is responsible for some of the financial problems of office buildings. However aggressive underwriting during the earlier years was also a factor.
In 2012, before the Seagram building refinanced to its current loan, it generated net operating income of $56mn. When its lenders underwrote the mortgage of $760mn the following year they estimated that the building would bring in 30% more revenue a year or $74mn.
It has never happened. The profit before interest payments and renovations reached a peak of $69mn in 2018, and has fallen ever since, reaching a low in 2022 of $27mn. Since then, Rosen’s firm RFR has added a 35,000 square-foot gym in the basement. This includes a 22-foot-high climbing wall, 150 seats for a multisport arena, and a spin studio.
Brokers said that the building was still a desirable place to live and was 92% full by the middle of this year. The $54mn it is expected to earn before interest, renovations and other costs in 2023 was about the same as in 2012.
John Griffin, professor at a Texas university, said that everyone will blame Covid for the losses. Wall Street’s aggressive subwriting of commercial mortgages is going to make this situation worse than it otherwise would have been.