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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
Stories about looming maturity walls are pretty common in financial journalism. There’s usually a chart that looks like this:
Along with a warning that two to three years from now, there’s a lot of debt that will need to be refinanced.
A coming wave of refinancings in a market is certainly important to investors and bankers, of course. But the worst fears about maturity walls are that borrowers won’t be able to refi their debt at all, and those fears rarely bear out. Two to three years is a decent amount of time, so companies can usually refinance their debt, work with lenders to “extend and pretend”, or plan
some light creditor-on-creditor violence liability management exercises.
That said, we’re less confident about the outcome of a maturity wall that looks like this:
The above chart is from TS Lombard’s Dario Perkins, and uses IMF data to map upcoming maturities of commercial real estate debt. Oh, and the volume of delinquent CRE loans at banks has already hit its highest level in a decade, as mainFT recently reported.
Perkins argues in a note that investors have been too bearish about the risks of a commercial-property meltdown ballooning into a new Global Financial Crisis:
While temporary factors have supported the residential property market in 2023, the consensus was always too bearish about the prospects for commercial real estate (CRE), not least once the central-bank backstop was in place. The risk was not a precipitous crash but rather a slow-burn (S&L-style) squeeze on asset returns and bank profitability. That squeeze will continue.
Still, a “slow-burn Savings & Loan-style squeeze” doesn’t sound pleasant. And the only way property markets will fully dodge the bullet is if central banks (and esp the Fed) not only stop raising rates, but also cut rates before tight policy puts too much stress on the financial system, Perkins writes:
The worry is that most of these explanations are tied to a common theme: the assumption that interest rates will remain at their current levels only for a brief period. Since this runs counter to central banks’ policy guidance, it seems premature to rule out further pain for property markets in 2024. The good news, however, is that we are still talking about a risk scenario that would produce only a mild recession compared with past cycles. And now that inflation is on a swift descent, there is a good chance we will avoid this pain altogether — as long as central banks pivot soon.
In a Thursday note, strategists at Goldman Sachs also highlight that the market for commercial real estate loans has been unexpectedly resilient, even after a steep rise in interest rates and a steep drop in occupancy in prime locations.
A total of $1.2tn of US commercial real estate loans will mature over the next two years, according to the bank. That’s nearly one-quarter of the market, the highest share since at least 2008.
Banks make up the majority of the lenders who will be helping borrowers scale that maturity wall — or not — holding about 40 per cent of the loans:
While many of the loans have “built-in extension options” that can push out their maturity (typically one year for CMBS, says GS), those can be “costly”.
But even costly modifications look reasonable when the alternative is not being able to refinance at all.
Thanks to deterioration in property-level financial performance, only about 25 per cent of conduit and single asset/single borrower CMBS loans will be able to refinance in the next two years, GS found. For the broader CMBS market, that figure is just 40 per cent.
GS has to make some assumptions about what securities can refinance, of course. The strategists settle on an LTV below 60 per cent; an implied mortgage rate from of at least 7 per cent; and a debt service coverage ratio above 1.3 to 1.5 depending on the property type.
As evidence of lender flexibility, GS breaks out the striking statistic that 80 per cent of office loans that have matured in the past four months haven’t fully paid off their principal:
While this naturally risks setting off a wave of commercial mortgage defaults, lenders have shown a willingness to cooperate with borrowers and modify loans. Maturity extensions have been particularly common, buying borrowers time for financial conditions to improve or for their property’s net operating income (NOI) to grow. ~80% of maturing office loans in the CMBS market have failed to fully pay off principal over the past 4 months, though far more of these situations have resulted in modifications rather than foreclosures.
Flexibility also helps the lenders, of course. As readers might guess, losses have been severe on office loans that have gone into default in 2023:
The pain isn’t over. Cap rates on commercial real estate properties have been slow adjusting higher, particularly compared to the increase in the 10-year Treasury yield. And the strategists echo Perkins’ argument that the extent of the damage depends on how long the Fed takes to cut rates. From the bank:
Primarily, the valuation reset across commercial real estate is still ongoing, in our view, evidenced by the fact that real 10-year Treasury yields have risen by considerably more than property cap rates (a common measure of rental yields) across commercial real estate segments. The longer interest rates remain elevated, the further commercial property prices could fall; based on Green Street data, broad property valuations have already fallen by 19% since their recent peak, with office properties depreciating by 31%. We expect this will disproportionately affect investors in real estate equity, both on the public and private sides.
At least office lenders can at least be reassured that they aren’t equityholders . . . yet.