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  • Writer's pictureCapital Bridge Partners

Challenges in the CMBS Market Amidst Office Property Markdowns

By Daniel, Gavin, and Stephen | Capital Bridge Partners 

Office property valuations continue to falter across the US.  Nowhere is this trend more evident than in the commercial mortgage-backed securities (CMBS) space, which has seen a sharp increase in defaults over the past year.

High interest rates affect all real estate classes.  However, it has been especially acute in the office market where the combination of high rates and the systematic shift to work-from-home have dealt a one-two blow and most liquidity has been sucked out of the market.  This year, 80% of the maturing office loans may not be able to refinance, according to a recent report by Moody’s Analytics.

These sector-wide issues tell part of the story, but there are other issues specific to CMBS. 

Given that the underlying loans are pooled, CMBS investors are typically comfortable taking on a higher loan-to-value ratio: in many cases, as high as 75%. As office values have plummeted, borrowers may prefer to hand back the keys to the lender rather than continue making payments.  Due to the fact that CMBS loans are non-recourse, borrowers have little incentive to protect under-water properties.  

Ideally, borrowers and lenders in this situation might agree to modify the loan terms in the hopes that borrowers could retain ownership and lenders could continue to receive payments. However, of the $8.1bn in CMBS that matured in 2023, only $2.5bn was extended under modified terms. This is because loan workouts are challenging under a CMBS structure. Borrowers, investors, their servicers, special servicers, and lawyers for each party are all involved in the conversation, and each has a conflicting incentive.  From a lender’s perspective, the goal is to maximize recovery.  However, the servicer, special servicer, and all the lawyers get paid more the longer the loan and/or property remains in limbo.  Given the investor really does not have a strong voice, the moral hazard is very high.  

Multifamily properties in San Francisco are likewise facing challenges.  While tenant demand remains strong, new rates on maturing loans are not affordable.  In fact, according to a report from Fitch Ratings, multifamily delinquencies for CMBS loans are expected to increase to $1.3bn in 2024, a level higher than their previous peak during the COVID-19 pandemic. 

In recent months, many prominent San Francisco multifamily portfolios have defaulted on maturing debt.  Veritas, a well-known San Francisco-based landlord, could not refinance approximately $900M in maturing apartment loans, paving the way for Brookfield to initiate foreclosure.  In February, Mosser similarly defaulted on an $88M loan linked to San Francisco apartments. Furthermore, Goldman Sachs and Ballast Investments are expected to transfer 1,200 apartments back to lender RBC Real Estate Capital Corp.  These trades highlight how even multifamily borrowers will hand over their properties to the lender if they can not afford new higher rates.  

These multifamily defaults are occurring despite properties performing as anticipated.  Firms are struggling to refinance due to the drastic interest rate increases, causing them to trade properties at significant discounts.  Intriguingly, a group may be defaulting on one loan while it is buying the debt on a different property.  

In the office space, we have seen examples of firms taking similar steps to improve their financial positions. Presidio Bay Ventures recently handed over a site approved for two five-story office buildings in San Francisco back to its lender, TDA.  Despite the foreclosure, TDA and Presidio Bay Ventures plan to collaborate on advancing the project and developing the site into a hub for innovation. Notably, TDA is a lender and a real estate investor which gives it the background to be a meaningful partner, whereas other Bay Area lenders often lack this expertise.  Perhaps more joint ventures of this nature will be a way of strategically combating some of the challenges borrowers and lenders will face in the CMBS. 

The office market faces broad, fundamental problems that will continue to affect valuations moving forward.  Commercial mortgage-backed securities and the issues they currently present are undoubtedly part of the story as well.  While the CMBS market alone will not make or break these sectors, it serves as an example of how pain points can emerge in a period of downturn.  Addressing these pain points will be critical for achieving both market recovery and long-term stability, especially as more debt accumulates over this year.  As seen with the success of recent joint venture initiatives during defaults, it may be time for lenders in the office space to stop thinking like lenders and instead start acting like partners.

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