Uneven Recovery in Commercial Real Estate

Thoughts on the Market

Office buildings continue to struggle in the post-pandemic era, but our Chief Fixed Income Strategist notes that other properties have turned a corner.

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Welcome to Thoughts on the Market. I am Vishy Tirupattur, Morgan Stanley’s Chief Fixed Income Strategist. Along with my colleagues bringing you a variety of perspectives, today I'll be talking about how the challenges facing the US commercial real estate markets have evolved and talk about where they are headed next.

It's Wednesday, Sep 11th at 10 am in New York.

Over the last year and half, the challenges of commercial real estate, or CRE in short, have been periodically in the spotlight. The last time we discussed this issue here was in the first quarter of this year. That was in the aftermath of loan losses announced by a regional bank that primarily focused on rent-stabilized multifamily and CRE lending in the New York metropolitan area. At the same time, lenders and investors in Japan, Germany and Canada also reported sizable credit losses and write-down related to US commercial real estate.

At that time, we had said that CRE issues should be scrutinized through the lenses of lenders and property types; and that saw meaningful challenges in both – in particular, regional banks as lenders and office as a property type.

Rolling the calendar forward, where do things stand now?

Focusing on the lenders first, there is some good news. While regional bank challenges from their CRE exposures have not gone away, they are not getting any worse. That means incremental reserves for CRE losses have been below what we had feared. Our economists’ expectations of Fed’s rate cuts on the back of their soft-landing thesis, gives us the conviction that lower rates should be an incremental benefit from a credit quality perspective for banks because it alleviates pressure on debt service coverage ratios for borrowers. Lower rates also give banks more room to work with their borrowers for longer by providing extensions. For banks, this means while CRE net charge-offs could rise in the near term, they are likely to stabilize in 2025.

In other words, even though the fundamental deterioration in terms of the level of delinquencies and losses may be ahead, the rate of change seems to have clearly turned. In that sense, as long as the rate cuts that we anticipate materialize, the worst of the CRE issues for regional banks may now be behind us.

From the lens of property types, it is important not to paint all property types with the same brushstroke of negativity. Office lots remain the pain point. Looking at the payoff rates in CMBS pools gives us a granular look at the performance across different property types.

Overall, 76 per cent of the CRE loans that matured over the past 12 months paid off, which is a pretty healthy rate. However, in office loans, the payoff rate was just 43 per cent. Other property types were clearly much better. For example, 100 per cent of industrial property loans, 96 per cent of multi-family loans, 89 per cent of hotel loans that matured in the last 12 months paid off. The payoff rates in retail property loans were a bit lower but still pretty healthy at 76 per cent, in clear contrast to office properties. Delinquency rates across property types also show a similar trend with office loans driving the lion’s share of the overall increase in delinquencies.

In short, the secular headwinds facing the office market have not dissipated. Office property valuations, leasing arrangements and financing structures must adjust to the post-pandemic realities of office work. While this shift has begun, more is needed. So, there is really no quick resolution for these challenges which we think are likely to persist. This is especially true in central business district offices that require significant capex for upgrades or repurposing for use as residential housing.

Overall, we stick to our contention that commercial real estate risks present a persistent challenge but are unlikely to become systemic for the economy.

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