Refinancing Risk Is High For CRE Borrowers

In its May meeting, the Fed held its policy rate at 5.25%-5.50% and indicated rate cuts won't occur until policymakers are confident that inflation is on a sustainable path toward the central bank's 2% target. S&P Global Ratings revised our forecast for a cut in the federal funds rate, which we now expect will come in December—several months later than we previously forecast.

The delay in rate cut until at least the fourth quarter of 2024 is unwelcome news. CRE borrowers that postponed refinancing with hopes for a rate cut in mid-2024 could get squeezed. As such, refinancing risk for debt maturities in the next two years remains high, particularly for struggling property types and properties that are unable to increase cash flows.

Table 1

The CRE financing market is a $3.7 trillion market (excluding bank owner occupied loans and government sponsored loans). Banks remain the primary source of capital for CRE, accounting for about half of overall lending, while insurance companies, CMBS, and mortgage REITs account for the bulk of the balance. The CRE exposure varies across the banking sector, with about 60% of these loans in the hands of banks with less than $50 billion in assets, and banks with CRE concentration could face greater risk of losing the confidence of depositors and counterparties.

Banks tightened lending standards in 2023 as asset valuation declined and real estate fundamentals slowed. The last Senior Loan Office Opinion Survey on Bank Lending Practices point to fewer banks further tightening lending standards, but lenders remain selective and they are only granting loan extensions or modifications if it makes economic sense. Though modest so far, we believe a rising number of CRE loans have been modified in some way, most notably through term extensions for banks. We also believe upcoming maturities are leading to a buildup in criticized loans as banks further assess their portfolios' creditworthiness.

The insurance sector remains an important source of capital for CRE, particularly for larger loans ($50 million-$100 million) with longer maturity (10 years) and has been an alternative source of capital for CRE borrowers as banks tightened lending. CRE loans by insurance companies grew about 2% in 2023, which lags the 4% growth in the overall CRE debt market.

The credit quality of the industry's CRE exposure is high, driven by the conservative nature of its investment in the space. While loan delinquency has edged up, this remains very low at 0.37% in 2023 and the exposure to the office sector remains limited.

For CMBS, we expect the refinancing picture to remain murky in the near term, especially within certain segments of office, retail, and multifamily. Deals approaching their maturity dates that have been unable to refinance given current market conditions have already led to sizable increases in the delinquency and special servicing rates. For struggling property types and properties unable to increase cash flows in the near term (e.g., class B office assets), fresh equity, rescue capital in the form of preferred equity or debt, or loan modifications may be needed to avoid foreclosures, defaults, and, ultimately, losses, as borrowers attempt to meet current debt obligations.

More certainty in the path of future interest rates may be needed for owners and borrowers to capitulate, which would bring greater transaction volume and price transparency (and losses). Benchmark rates have stabilized and will eventually decrease from current levels. To that end, we did see some signs of increased issuance in the beginning of this year. Still, a more robust recovery may take more time. According to CBRE Group Inc., U.S. CRE investment volume fell 19% in the first quarter of 2024 after a 44% decline in the fourth quarter of 2023. That said, U.S. CMBS issuance is up year over year from a relatively low level in 2023, largely owing to robust single-borrower volume and that's driven by offerings in some of the better performing sectors, like industrial and lodging.

We expect mortgage REITs and CRE finance companies will remain selective with new originations and focused on preserving liquidity by cutting dividends to navigate through the difficult CRE market conditions.

In terms of loan performance by lender, CRE delinquency rates remain low for banks and very low for insurance companies, compared with those in the CMBS market. This reflects more conservative underwriting and flexibility to modify terms by banks and insurance lenders for these recourse loans. In addition, the CRE sector is diversified enough to cope with the poor performance of some property types, including offices.

Downgrades Outpace Upgrades

Downgrades have been accelerating across the CRE sector since early 2023. For equity REITs, we downgraded 18 issuers and upgraded six upgrades in 2023 and four downgrades to two upgrades so far in 2024. Office REITs account for the majority of the downgrades, and we expect operating pressure to persist for at least the next two years given declining occupancy and net effective rents in the office sector. There were a significant number of downgrades in the office sector, including several fallen angels and about 40% of our ratings on office REITs are currently speculative grade (versus 20% of the broader REIT sector).

For U.S. mortgage REITs, we downgraded two companies (out of six ratings) and revised our outlook to negative on one so far this year. These actions mainly reflect deteriorating asset quality and rising liquidity needs. Given the fluid conditions in the sector, downward rating pressure remains and we could take further negative rating actions if asset quality continues to deteriorate, if leverage approaches our downside thresholds, covenant cushions erode, or liquidity becomes strained, in our view.

For CMBS, we expect overall delinquency and special servicing rates will continue to rise for the balance of 2024, driving downgrades. We saw a spike in downgrades in late 2023 after we revised our capitalization rate assumptions for class B office assets, and office-backed single asset single borrower (SASB) transactions have generally driven recent downgrades. Pace of downgrades accelerated since 2023, with 433 downgrades vs. 1 upgrade through April 30, 2024 (out of over 2,600 outstanding ratings).

For U.S. banks, although there have been no downgrades so far related solely to CRE, there have been several outlook changes (earlier this year, we revised our outlooks on five banks to negative related to CRE, and there were two banks placed on negative outlook last year, partially related to CRE).

In the next sections, we assess refinancing risk by asset class and discuss banks and life insurance companies' exposure to CRE debt.

Banks

The impact of declining CRE prices on some regional banks' creditworthiness has come into further focus.   Credit quality metrics, such as delinquencies and charge-offs, are rising but still relatively benign for most banks. But criticized CRE loans have picked up and are high at some banks, particularly as more CRE loans reach maturity. Challenges at New York Community Bancorp. (not rated), which triggered a plunge in its stock price and an eventual capital raise, also have increased the focus on regional bank CRE exposures. (We define CRE as loans backed by investor-owned, multifamily, and construction and development properties).

S&P Global Ratings recently reviewed its rated banks, focusing largely on the banks with highest proportion of loans to the CRE sector. As a result, we revised outlooks on five regional U.S. banks to negative from stable (see "Outlooks On Five U.S. Regional Banks Revised To Negative From Stable On Commercial Real Estate Risks; Ratings Affirmed").

Chart 1

Despite the stress in CRE markets, there are a number of offsetting factors that should help rated banks' loan portfolios withstand significant CRE losses.   CRE behaves differently across distinct geographies and property types. The granularity of banks' CRE portfolios, particularly for regional banks, often is an offsetting positive factor. Indeed, each property type in a bank's CRE portfolio will likely behave differently from a cash flow standpoint depending on its location, tenant makeup, and condition of the property. Besides this, banks have a built-in cushion to absorb CRE write downs as loan-to-value ratios at origination typically range from 50%-65%. Lastly, office properties--the most stressed asset class within CRE--usually only represents a small portion (low- to mid-single digits) of rated banks' total loan portfolios.

Banks maintain a cautious approach to refinancing.   For most rated banks with meaningful CRE exposure, we believe roughly 10%-30% of CRE debt comes due this year, but some banks have a significantly higher percentage.

In general, when a loan approaches maturity, the bank lender will assess the value of the property. If the borrower cannot, or chooses not to, obtain financing from another lender, the bank may seek additional equity from the owner of the property if its value has fallen to help protect the bank in case there is default. If the loan was originally fixed rate, refinancing could pressure the ability of the borrower to service the loan if the refinancing is at a significantly higher rate.

As relationship lenders, banks may not view foreclosing on CRE property as their best course of action if extending the terms of a CRE loan or restructuring the debt would offer better long-term prospects. Also, with funding costs rising, we believe banks will do their best to maintain or add earning assets to preserve net interest income and profitability. As long as a CRE loan makes economic sense, a bank with balance sheet capacity is likely willing to extend a loan.

Although modest so far, we believe a rising number of CRE loans could be modified in some way, most notably through term extensions. We also believe upcoming maturities are leading to a buildup in criticized loans as banks further assess their portfolios' creditworthiness.

Given that CRE delinquencies and charge-offs have remained relatively low, we relied on other factors to try to determine how resilient the banks we rate could be to an unexpected build up in losses in their CRE loan portfolio. One factor involved stress testing the earnings capacity of a bank to withstand a sudden need to build up reserves for potential CRE losses. As shown in chart 2 below, a 50-basis-point (bp) increase in provisions in one quarter seems manageable for rated banks with greater than 200% of tier 1 capital exposed to CRE. However, a sudden 100-bp increase raises the specter of potential market confidence sensitivity, in our opinion, particularly for the highest exposed CRE banks (see chart 2). Please see summary of CRE stress testing results in our commentary, "Some U.S. Regional Banks Could Face Higher Risk If Commercial Real Estate Asset Quality Worsens," published March 26, 2024.

Chart 2

Insurance

Most of the insurance industry's CRE sits on life insurers' balance sheets.   The U.S. insurance industry, across life, property & casualty, and health holds approximately $1.1 trillion of CRE in various investment formats. The largest part is the $609 billion of commercial mortgage loans that life insurers have directly underwritten. These mortgages are nearly all fixed-rate and tend to be longer term loans, which fit well with life insurers' long-term liabilities. The weighted-average term of commercial mortgages underwritten by life insurers during 2023 was 7.2 years. U.S. life and property & casualty insurers hold a total of $270 billion of CMBS, the vast majority of which are rated in the 'AAA' category, with only small sliver rated below investment grade. Health insurers do not hold any meaningful amount of CMBS. The balance of the CRE exposure is spread across equity holdings and various smaller investments via funds, joint ventures, etc.

Chart 3

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Chart 5

The exposure to office mortgages is slowly decreasing.   Life insurers have significantly slowed down the underwriting of new mortgages on office properties over the past few years and have found value in other property types. In 2023, the total amount of office mortgages actually declined to $123 billion from $133 billion in the prior year, while the dollar amount of other property types grew. This is not due to losses–-delinquencies and foreclosures remains very low–-but has happened organically as office mortgages have matured and the lack of new office-loan production has resulted in reduced exposure. At the same time apartment/multifamily and industrial mortgages grew 6.1% and 13.1%, respectively. At the end of 2023, office represented roughly 20% of commercial mortgages, or about 2.3% of total invested assets.

Chart 6

U.S. life insurers tend to be conservative underwriters of commercial mortgage loans.   Mortgages are typically written with low loan-to-values (LTVs), high debt-service coverage ratios (DSCRs) and generally focus on above average quality assets with strong sponsors. At the end of 2023, the weighted-average of LTV levels of all property types was under 60%, based on the most recent appraisals. Office buildings are unsurprisingly fairing worse than other property types, with nearly 12% of loans having very high LTVs of over 80%, and a weighted-average LTV of 58.2%.

Life insurers' conservative underwriting has historically helped to keep delinquencies and foreclosures low, and thus far the commercial mortgages performance has been holding up well, especially compared with the broader CRE market.

Life insurers have been utilizing their direct relationships with borrowers to restructure loans and make short-term extensions at a higher rate than they have historically. We analyzed insurers' statutory financials to identify loans that were extended for four years or less at current market rates. These loans are not restructured, but are performing and current, and are considered in good standing under statutory accounting rules. We believe such a short-term extension might suggest that the borrower had trouble refinancing, and that the extension may have prevented a default. That said, there is no way to be certain of the rationale for the extension or what the outcome would have been otherwise. It's also important to note that life insurers typically extract concessions from borrowers, such as a principal paydown or property improvements, in exchange for an extension.

Chart 7

The industry will likely be able to absorb the stress from CRE.   We can assume the current stress in CRE, especially office, will lead to losses on some commercial mortgages held on insurers' balance sheets. The current level of delinquencies and foreclosures will not generate meaningful losses for the insurance industry, but there is no guarantee that loan performance will not continue to deteriorate. Nevertheless, the combination of low LTVs and limited exposure to office properties will likely make losses manageable even if office property values plummet. Our analysis shows that even if all office buildings experience a 75% decline in value, which is an extreme scenario, the life industry will lose roughly 13.5% of its equity (statutory surplus).

The high credit quality of the industry's CMBS holdings is also likely to limit impact on insurers' balance sheets, even under a severe stress scenario.

CMBS

Refinancing risk is a perennial topic in U.S. CMBS, since loans and transactions are almost always structured with bullet maturities. That said, the market faces a different set of circumstances than it did during the cycle of falling interest rates. This is not just due to higher current rates, but is also a consequence of market dynamics.

Before the Great Recession, an overwhelming majority of the sector was long-term (mostly 10 year) fixed-rate conduit (multiborrower) transactions. Over the past few years, a much higher percentage of the market has been single-borrower deals, many of which are floating rate and have shorter tenors. In addition, within the past couple of years, a five-year conduit product emerged and has been relatively popular with both borrowers and investors.

As previously mentioned, refinancing conditions have become more challenging within the past 18 months or so. This is due to declining rent growth, and even rent declines in some areas, falling property values, and related, higher interest rates.

Coupons of 6.0%-8.0% in recent years have replaced the 3.0%-5.0% coupons (and in some cases below that) from the 2020-mid 2022 period. Combined with tighter lending conditions, refinancing risk has naturally risen. Not surprisingly, monthly issuance levels slowed down alongside coupons as interest rates rapidly increased.

On the plus side, many market watchers think benchmark rates have stabilized and will eventually decrease from current levels. The timing, however, seems to have taken longer than the market was initially pricing in. To that end, we have seen some signs of increased issuance in the beginning of this year. We largely attribute this to the bullish sentiment that prevailed over the past four to six months that began when the Fed signaled the end of the rate increase cycle. We will continue monitoring how issuance reacts in the second half of 2024, as expectations have shifted to a much slower pace of benchmark rates reductions.

For struggling property types and properties that are unlikely to increase cash flows in the near term (e.g., class B office assets), fresh equity, rescue capital in the form of preferred equity or debt, or loan modifications may be needed to avoid foreclosures, defaults, and, ultimately, losses, as borrowers attempt to meet current debt obligations. More certainty in the path of future interest rates may be needed for owners and borrowers to capitulate, which would bring greater transaction volume and price transparency (and losses).

To determine market exposure to maturing assets, we look at the data for outstanding conduits and single borrower transactions.

Conduits

Chart 8

Looking at the breakdown between property types, we note:

• Loans backed by office assets account for the largest share of conduit maturities over the next 10 years, at about $104 billion of the $365 billion total. On average, roughly half of conduit office loans (based on loan balance) are backed by class B assets, which may face an even more challenging refinancing environment than class A properties. During 2024-2026, $35 billion in overall office loans come due, or 26% of the total, a close second to retail over that period.
• Retail loans represent the second-largest group ($86 billion, or 24%) of maturities for the conduit sector through 2034. Some $70 billion of that total comes due through the end of 2029. Retail has comprised the highest percentage of recently issued deals, at 35% of first-quarter offerings.
• Lodging assets have made up a steady low-double-digit percentage of conduits over the past 13 vintages (excluding 2021 and 2022, when the pandemic affected the sector). Performance rebounded and their delinquency and special servicing rates have since fallen significantly. Roughly $20 billion in lodging loans comes due through the end of 2026.
• Multifamily also faces about $20 billion in maturities during the next three years. Slowing rent growth in certain markets may increase refinancing risk somewhat, although a still expensive (and high mortgage rate) single family home market likely mitigates that risk to some extent.

Looking at maturities for outstanding private-label (nonagency) conduits, we observe the amount of conduit loans maturing overthe next few years are roughly within the $40 billion-$60 billion range, excluding the rest of 2024. We attribute this to issuance remaining well below the peaks that occurred prior to the Great Recession (e.g. $198 billion in 2006, $229 billion in 2007). The property type composition of maturing loans in any given year generally reflects the broader conduit sector. In other words, office (and mixed use), retail, multifamily, and lodging dominate most years (the other category includes mixed-use, which is likely mostly office/retail as well).

SASB

Chart 9

A look at the loan-maturity profile for SASB loans shows:

• SASB loan maturities peak in 2026-2027, reflecting the growth of this market over the past few years. Most of the market is now floating rate, although there are still longer-term, fixed-rate deals outstanding. In general, the property type mix is relatively less concentrated in office and retail versus the conduits.
• Industrial plays a much larger role in SASB versus conduit (although they are still a steady albeit low percentage of conduits most vintages), mainly due to the large portfolio transactions common within the space. Lodging has been similar in that regard.
• Office maturities make up a significant percentage of near-term maturities, but begin to fall off as the sector became less favored by SASB investors over the past few years.

Mortgage REITS (CRE Financial Companies)

Given the current interest rate environment, we expect CRE lenders will remain challenged. However, the extent of credit quality deterioration this will cause will depend on location, property type, and the underwriting quality of the properties securing the loans.

Office loans generally remain the most troubled loan type for most lenders.   Amid uncertainty about future office demand and secular changes involving remote work, office property prices have plummeted in many markets, with limited price discovery. We think it's still likely that CRE finance companies' loan portfolios will deteriorate further, particularly those with high office exposures.

Multifamily loans have also come under strain due to slowing rent growth and high interest rates.   A rise in troubled multifamily loans could exacerbate asset quality issues because most CRE lenders have been increasing their exposure to multifamily since 2020 to offset office exposure.

Chart 10

To navigate through difficult CRE market conditions, we believe CRE finance companies will remain selective with new originations and focus on preserving liquidity.   We've seen a precipitous decline in many CRE lenders' distributable earnings. This has prompted some companies to cut their dividends to protect liquidity.

Through first quarter of 2024, CRE finance companies built up credit loss reserves related to underperforming loans, and they changed their own internal risk ratings on many of their loans to the higher-risk "4" and "5" categories. At some of the CRE lenders we rate, the value of the higher-risk loans is equal to 75%-100% of their adjusted total equity (our measure of their capital), which we view as elevated. In our view, rated CRE lenders will likely see asset quality deterioration as more loans move toward maturity, likely pressuring operating performance.

Chart 11

The companies we rate depend on secured financing in the form of repurchase facilities that often have an interest-coverage covenant requirement. Higher interest rates reduced the cushions to interest-coverage covenant requirements, and we see companies prudently working with lenders to amend the threshold by reducing it. Given the ongoing stress in CRE markets, the risk of margin calls related to repurchase facilities remains elevated, in our view. However, most of those facilities allow margin calls only based on credit valuation adjustment, rather than on changes in market interest rates and credit spreads.

Chart 12

High rates and uncertainty in the CRE markets has limited these companies' access to debt issuance, particularly in the unsecured market. These companies have modest refinancing risk in 2024-2025 related to their corporate debt before the refinancing risk exponentially rises to about $3.7 billion in 2026 and $3.0 billion in 2027.

Since 2023, of the six CRE lenders we rate, we only saw Starwood Property Trust access the unsecured market. A drop in rates that supports that access, which our economists don't expect before December 2024, could be a positive for these companies.

Chart 13

U.S. Equity REITs

Refinancing conditions remain challenging for U.S. REITs as fundamentals decelerate across property types while interest rates remain high.   Rated U.S. REITs face a growing debt maturity wall over the next two years with aggregate debt maturities of $40 billion in 2025 and $53 billion in 2026, compared with $28 billion in 2024. By sector, retail and health care REITs face the highest level of debt maturities with each over $8 billion in 2025 and $10 billion in 2026. While debt maturities for office REITs are modestly lighter, we expect office REITs to face heightened refinancing risk given weaker fundamentals due to the secular shift to hybrid work.

Chart 14

Office REITS could suffer from muted job growth (there is still high correlation between job growth and demand for office space), low tenant retention rates (which are still around 10% below pre-pandemic levels), and high vacancy rates.   The valuations of office assets, which declined sharply over the past two years (35% for class A office and over 50% for class B properties), could remain stressed until the Fed starts to cut rates in late 2024. Office REITs' unsecured bonds are trading about 200 bps wider than the broader rated REIT portfolio (average of 170 bps) and sharp increases in borrowing costs have put significant pressure on fixed-charge coverage ratios. In some cases, expiring hedges for rate caps could lead to further deterioration in coverage ratios as renewing hedging positions has become expensive.

From an equity perspective, office REITs are trading at a steeper discount to analyst estimates of net asset value (NAV) versus the broader REITs (28% discount compared to a 15% discount for the entire sector), limiting their ability to issue equity. REIT equity issuance has slowed significantly in 2024 (approximately 60% lower in 2024 compared to the same period in 2023) despite some narrowing in NAV discounts in recent months.

Still, financing conditions have improved moderately, particularly for higher rated REITs, as bond spreads have narrowed by about 100 bps and are close to 2022 levels for most property types. We have started to see some recovery in bond issuance in the first quarter of 2024, although overall issuance is still trending about 8% below 2023 levels. We expect limited increases in bond issuance over the near term given the higher for longer rate environment through 2024 but expect improvement sequentially as the pace of rate cuts is expected to accelerate in 2025.

REITs maintain largely unencumbered asset bases and can sell assets to meet liquidity needs. However, the real estate transaction market remains muted and asset sales have been much slower than expected given that the bid/ask spread remains wide between buyers and sellers amid tighter financing conditions. We're seeing an uptick in M&A with Blackstone acquiring multifamily REIT Apartment Income REIT Corp. (AIRC) in a transaction valued at approximately $10 billion in April 2024.

We expect transaction activity to gain momentum in 2024 as the interest rate environment stabilizes and compelling opportunities emerge, including more distressed assets coming to market, which could create acquisition opportunities for REITs with a cost of capital advantage. More price discovery from an increased volume of transactions would help support asset valuations.

Our rating bias on U.S. REITs remains negative and the number of office REITs fallen angels has risen.   Overall, we expect REIT credit quality to weaken modestly in 2024, as 27% of credits either have a negative outlook or are on CreditWatch with negative implications, compared with just 6% of credits with a positive outlook. This negative rating bias is largely driven by our continued negative view on office REITs and speculative-grade issuers facing significant refinancing risk, while some retail REITs have positive outlooks due to better-than-expected performance.

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For office, we expect operating pressure to persist for at least the next two years given declining occupancy and net effective rents. Given the significant number of downgrades in the office sector, including several fallen angels, about 40% of office REITs are currently speculative grade (versus 20% of the broader REIT sector).

Given higher borrowing costs, tighter lending conditions and valuation pressure, we're seeing a meaningful deterioration in capital structures with the weighted average maturity (WAM) of debt for a few issuers dropping below three years. Typically, we believe companies with short debt maturity ladders (less than three years for real estate entities) face greater refinancing risk than their peers with longer-weighted average debt maturities. For example, we lowered the ratings on Brookfield Property Partners to 'BB' with a negative outlook from 'BBB-' on CreditWatch negative on Dec 21, 2023, reflecting elevated near-term maturities. We also revised the capital structure modifier to negative due to its weighted average debt maturities falling below three years, excluding extension options.

Office REITs that are facing declining cash flows due to weak operating results have cut or suspended dividends, pulling back on development spending to preserve liquidity and financial flexibility. As debt maturities loom, liquidity positions have weakened for some REITs, resulting in two issuers with less than adequate liquidity (Diversified Healthcare Trust and Medical Properties Trust) and two with weak liquidity (Forest City and Office Properties Income Trust). After a period of minimal defaults since the global financial crisis, we expect the number of defaults to increase over the next year. We recently lowered the rating on Office Properties Income Trust to 'CC' given its proposed plan of a distressed exchange for potentially several series of unsecured notes.

Related Research

• U.S. Banks Q1 2024 Update: Pockets Of Weakness And Strength, May 16, 2024
• Commercial Real Estate Exposure At U.S. Life Insurers, May 29, 2024
• CreditWeek: What Does The Delay In Fed Rate Cuts Mean For The Economy And Credit?, May 9, 2024
• Some U.S. Regional Banks Could Face Higher Risk If Commercial Real Estate Asset Quality Worsens, March 26, 2024