Defaults on Office Loans Reaching Historic Levels

New York, NY, April 30, 2024-"Defaults are reaching historic levels in the office market, as a growing number of owners capitulate to persistently high interest rates and weak demand,” according to the Wall Street Journal.

“More than $38 billion of U.S. office buildings are threatened by defaults, foreclosures or other forms of distress, according to data firm MSCI. That is the highest amount since the fourth quarter of 2012 in the aftermath of the 2008-2009 financial crisis. 

“Office owners are paying back their loans at a much slower rate. As recently as 2021, more than 90% of office loans that were converted into commercial-mortgage-backed securities were paid off when they became due, according to Moody’s. Last year, that figure fell to 35%, the worst payoff rate in the history of the data, which goes back to 2007.

“‘It’s a pretty stark change,’ said Matt Reidy, director of Moody’s commercial real estate economics.

“Today’s high interest rates are particularly problematic because commercial-property owners typically borrow at least half of a building’s cost. Most of the mortgages that are coming due now were made when interest rates were much lower than now.

In a normal office market, many landlords would be able to pay the higher rates. But since Covid-19, the office market has been far from normal. Demand has nosedived as many businesses allowed employees to work from home and reconsidered the amount of workspace they need.

“Tenants signing new leases are closely scrutinizing their landlords’ financial health. They want to be sure the owner isn’t going to lose its property to creditors and has the money to add promised amenities.

“‘Tenants are very focused on landlords who can put additional capital into the buildings because they want to get their employees back,’ said Adam Edwards, managing director at real-estate investment banking firm Eastdil Secured.

“Tenants have good reason to be wary. In the next 12 months, $18 billion of office loans converted into securities will mature-more than double the volume in 2023. Moody’s projects that 73% of loans will be difficult to refinance because of the properties’ income, debt levels, vacancy and approaching lease expirations.

“Earlier this year, industry hopes were high that the Federal Reserve would begin cutting its interest rates this year. But in recent weeks, those hopes have faded as inflation concerns have persisted.

“The U.S. office vacancy rate currently is at a record 13.8%, compared with 9.4% at the end of 2019, according to data service CoStar Group. In the first quarter of 2024, tenants signed leases for about 102 million square feet, about 10% below the 2019 average, CoStar said.

“The financial upheaval in the office market is pressuring U.S. banks, insurance companies and other lenders. Commercial real estate losses in the fourth quarter at New York Community Bancorp sent shock waves down Wall Street evoking memories of bank failures last year.

“Regional banks in recent weeks have been reporting high net charge-offs due to commercial-property exposure. At PNC Financial Services, for example, they were more than $50 million in the first quarter, slightly less than $54 million in the fourth quarter of last year but much higher than about $10 million one year earlier.

“Office loans were a contributing factor. ‘The problem you have in office is, in many instances, there is no cash flow at all,’ PNC Chief Executive Bill Demchak said on an earnings call. ‘It is really a unique animal at the moment.’”