U.S. commercial real estate faces a wall of debt

While Wall Street is hitting all-time highs on the prospect of at least three and possibly more interest rate cuts by the U.S. Federal Reserve Bank, a key sector of the U.S. economy with important ties to the financial system is being hit by rate hikes since March 2022.

According to the Mortgage Bankers Association, as reported by the Financial Times (FT), "billions of dollars of debt will have to be repaid this year on hundreds of large US office buildings that their owners are unlikely to be able to refinance at current interest rates."

This year, $117 billion worth of debt secured by office buildings is due to be paid off or refinanced. Many of the mortgages were written when interest rates were at ultra-low levels due to the quantitative easing policies that the Fed and other central banks pursued for nearly a decade after the 2008 financial crisis and the 2020 COVID pandemic crisis.

Commercial real estate sector

The FT cites remarks from a real estate lawyer at a large firm who said some refinancings are proving problematic. "We are seeing deals where even experienced borrowers are deciding to leave buildings and asking their lenders if they would like to take back the keys," he said.

The commercial real estate sector has already been shocked by the collapse of Austrian firm Signa in December, which is now putting half of the Chrysler building in New York up for sale to raise money.

Signa's owner, billionaire Rene Banco, assembled what has been described as a "financial time bomb" by tapping into "cheap financing left and right" as one description describes it, his activities were just one of the more extreme examples of a broader process.

Higher interest rates and overdue debts

Last November, a report from think tank BankRegData said delinquent commercial real estate debt reached its highest level in a decade, a result of higher interest rates and lower demand for office space due to the rise of telecommuting in response to the pandemic.

Loans on which property owners missed more than one payment rose 30 percent, $4 billion, in the third quarter of 2023 and increased by $10 billion over the past year.

Delinquencies are expected to continue as BankRegData's Bill Moreland tells the FT that commercial real estate lending is "getting ugly fast".

Challenges for banks and REITs

Large banks have the resources to weather the storm, at least for now, but most of the lending in the U.S. is done by small regional banks. They have already suffered from rising interest rates due to the loss of value in government bonds, in which they invested their funds, as these were considered "safe" securities.

This situation led to the collapse of three banks in March, but the problem affected many banks where their total liabilities exceed the book value of their assets.

FT reports that last month "a group of American economists found that 40 percent of office loans on banks' balance sheets are underwater, which could lead to problems for dozens of regional banks holding them."

Problems for commercial real estate are long-term. Last April, Bloomberg reported that a "wall" of commercial and real estate debt worth nearly $1.5 trillion is due to be repaid by the end of 2025.

Problems in the REIT and construction sector

Morgan Stanley analysts noted at the time that there were refinancing issues in the first planned line, as valuations of office and retail properties could drop by 40 percent from peak to trough, increasing the risk of defaults. Since then, the situation has only worsened, as Bloomberg points out, and it will continue to deteriorate.

Not only small and regional banks are under pressure. Problems are also emerging in the upper segment of the financial sector and commercial real estate.

Last week, the Wall Street Journal reported that one of the "most successful fundraising vehicles" on Wall Street—non-traded real estate investment trusts (REITs), which allowed investors to participate in the construction boom from 2019 to 2022—"went off the rails" last year. The outflow of funds from these trusts surged as investors sought to get their money back, and at times, the funds had to implement rules to limit the speed of withdrawals.

Non-sector REITs raised $9.8 billion in the year leading up to November, compared to $33.2 billion in 2022, as investors pulled out $17.4 billion.

The article states that although the pace of capital outflows slowed somewhat by the end of last year, outflows will exceed capital inflows in 2024. This makes the business a symbol of the worst downturn ever seen in commercial real estate since World War II.

An article in the New York Times at the end of last year states that the construction boom that has changed the skyline of Manhattan over the past 25 years is over. "Rising construction costs and interest rates have significantly increased building prices. Banks are increasingly reluctant to finance such construction, while Manhattan is experiencing record levels of office space vacancies," the article says.

Office building developers have been hit by a double blow: first, a decrease in demand due to COVID, and then a surge in interest rates, which are the "kryptonite for an industry built on debt."

At the end of November, nearly 18 percent of all office spaces in Manhattan were available for rent, with most of them located in older buildings constructed after World War II.

The average rent for office space in Manhattan is $75 per square foot. However, with the rising costs of construction, rates, and increasing interest rates, developers of new buildings will have to charge between $200 and $300 per square foot.

Such figures, along with the growing problems in commercial real estate across the country, indicate that the boom of the last 25 years, driven by some of the lowest interest rates in history, is over, and financial reckoning is coming.