CMBS defaults keep arising, who should be more vigilant?

The default of deep-pocketed landlords shocks the market

Firstly the Brookfield fund’s default of $784 million CMBS backed by two prime office towers in Los Angels; followed by a Pacific Investment Management Co. Office landlord default on $1.7 billion mortgage notes. This week, Blackstone, the world's largest private equity fund and asset management company, announced to have defaulted on $562 million CMBS. The successive defaults have shocked the global alternative investors, what is the future of the office CMBS?

Reason for default: high-interest rate and weak commercial real estate market

One important reason is, the banks are not willing to refinance commercial real estate projects, which makes the landlords cannot pay for the principal and interest of previous CMBS products by re-pledge their assets. According to data from the Mortgage Bankers Association of the United States, commercial real estate loans, the underlying target of CMBS, fell by 10% year-on-year to $804 million last year, and this year are expected to have a further fall of 15% to $684 million.

At the same time, the CMBS trading has plummeted, which leads to the landlords cannot issue new CMBS products to repay the old ones. Because of the sharp increase in the interest rate, and the cost of issuing new CMBS products arising correspondingly, many financial institutions would rather choose not to issue securities than bear a soaring high financing cost. Besides, because of the return uncertainty of commercial real estate, some CMBS products even though are issued, and just a few investors are purchasing them. Data show that until mid-February, the scale of US CMBS issuance was only US$4.27 billion, a drop of more than 85% from $29.38 billion in the same period last year.


Figure 1: Historical CMBS Issuance

Notes: Data includes private label conduit, SASB, CRE CLOs, and small balance transactions. Source: Bloomberg; Unit: Million dollars

The sharp rising interest rate also has damaged the transaction in the commercial real estate market. In 2022, the price of American commercial real estate has dropped by 13%, high-interest rates cut down the return for potential investors, which makes investors are losing interest in commercial real estate investment, coupled with the outbreak of the Ukraine war, landlords have not been able to sell assets in time to get back their money for the repay the debt.

In the short-term future how severe this problem would be? Depends on the interest rate

According to a report from Trepp, around 920 million CMBS expired in 2023 and 2024 European rating agency Scope Ratings was warning, about one-third of these CMBS loans are at high risk of refinancing.

While the delinquency rate for office commercial mortgage-backed securities remains relatively low, according to Trepp, the delinquency rate of the office building was 2.38% in February of this year, but the CMBS default rate has risen fast recently from 1.58% of last December.

If the Fed has to raise interest rates for a longer period to fight against inflation, the problems of delinquency rate might rise further in the foreseeable future, and the risk of economic recession will be more serious.

In long-term, don’t give up the office market, a good office performs better than you thought

Because of the “flew to quality”, the performance of office buildings show some divergence after covid. Those CMBS bets on the old office building might be riskier, such as the struggling Manhattan old office building, and the suburban small office buildings that the defaulted Blackstone CMBS was backed by. In factor, investors’ losing interest in these secondary-quality properties was also the reason why Fitch downgraded the ratings of Blackstone CMBS last year.

Those who invest in green and prime office should feel relief. Data shows two third of the space that was leased in London for the first 9 months of 2022 is rated “very good” or higher. Even though the vacancy rate of the London office market has doubled since the outbreak of Covid to 9%, the green buildings still rent out at a surprisingly fast speed. According to the data from Savills Inc., since 2018, the rents of BREEAM-certified buildings in London keep going up while those of the non-certified buildings are dropping. Moreover, other countries are also pushing forward the process of sustainable building, the Netherlands enforced the enrollment of green certificates, and commercial office buildings with energy labels D or lower can no longer be (re)leased, financed, or transacted. Research by Eichholtz et al (2019) comparing the mortgage spreads between green and non-green building also support the market’s preference for sustainable building from the lender’s perspective.

Office buildings are not abandoned, sustainable and the prime office will be the survivor!