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Stressful Conditions For U.S. Commercial Real Estate Are Raising Refinancing Risks


Weekly European CLO Update


U.S. Credit Card Quality Index: Monthly Performance--August 2023


SF Credit Brief: Overall U.S. CMBS Delinquency Rate Increased 18 Bps To 3.8% In September; Office Loan Delinquency Rate Climbs For Ninth Consecutive Month


SF Credit Brief: CLO Insights 2023 U.S. BSL Index: CLO ‘CCC’ Exposures Up; Scenario Analysis On 'BB' O/C Test Cushions

Stressful Conditions For U.S. Commercial Real Estate Are Raising Refinancing Risks

The Federal Reserve's aggressive monetary policy tightening in the face of nagging inflation, combined with secular shifts in CRE (particularly in the office sector), are heightening refinancing risks for many borrowers and the strains won't likely ease any time soon.

Pressures on credit quality for rated REITs and CMBS look set to persist for at least the next one to two years, as declining demand dampens rental growth and occupancy rates while borrowing costs escalate. This comes as turbulence in the banking sector further strains financing conditions, given that U.S. banks account for the bulk of CRE lending (see chart 1).

Chart 1


The Pace Of Downgrades Will Pick Up

Downgrades continue to outpace upgrades in the REITs sector, and we currently maintain a negative bias for the sector with 16% of ratings with negative outlooks. Given our view for deteriorating fundamentals in the office sector, we have downgraded a number of office focused REITs and maintain a 50% negative bias for the office REITs. This means we expect more downgrades to come in the next year. In addition to weaker fundamentals, office REITs also operate with higher debt leverage and have more exposure to development projects. While REIT remains largely investment grade, a few of the office REITS could become fallen angels. Still, the pace of downgrades is far lower than levels seen in the global financial crisis (GFC) given the pressure is mostly on the office sector. For mortgage REITs, we expect some deterioration in asset quality for these CRE lenders with exposure to office, retail malls and hotels, as the weaker economic environment creates challenges for borrowers in the next few years—likely meaning a rise in nonaccruals and loan-loss reserves. So far this year, of the six CRE lenders we rate, we have downgraded KKR Real Estate Finance Trust Inc. (B+/Stable/--) one notch and revised our outlook on Blackstone Mortgage Trust Inc. (BB-/Negative/--) and Claros Mortgage Trust Inc. (B+/Negative/--), reflecting higher leverage and deteriorating asset quality

CMBS performance remains challenged by property-specific secular headwinds, multi-decade record inflation, rising interest rates, and stress in the banking sector. The U.S. private-label CMBS (nonagency) overall delinquency rate increased by 39 basis points (bps) month over month to 3.2% in May. Office delinquencies spiked by 120 bps to 4.0% and are up over two percentage points since the beginning of the year. Also during May, special servicing rates increased for office (97 bps; the largest month-over-month increase since we began collecting data in July 2020) and retail (12 bps) loans; decreased for multifamily (16 bps) and lodging (12 bps) loans; and remained unchanged for industrial loans. This is key as the special servicing rate is a reliable indicator for future increases in delinquencies and reflects the difficulty of paying off or refinancing loans. We expect overall delinquency rates to tick up in 2023. In terms of our rated CMBS surveillance book, we have taken several downward rating actions in the past 12 months, especially with regard to single-borrower retail and, more recently, office transactions in which loans were showing varying magnitudes of stress. This trend is likely to continue through the year.

Higher-for-longer interest rates will weigh on credit quality as fundamentals slow with office faring worse than other property types

After the Fed raised its target rate to 5.00%-5.25% at its May meeting, markets are now pricing in rate cuts by the end this year. S&P Global Economics believes policy makers won't do so until the middle of next year. Inflation is slowing but remains well above the central bank's target of 2%, the U.S. economy has proven surprisingly resilient, and the labor market remains remarkably tight (albeit with a number of high-profile layoffs sowing some concerns). Acknowledging the high degree of uncertainty, we think the first Fed rate cut won't come until the middle of next year and that the benchmark federal funds rate will be 4.0% until late-2024.

Against this backdrop, diminished demand for office space and the potential longer-term effects on fundamentals from hybrid work (vacancies/rents) and valuations are the key risks for the office sector right now, and likely will remain so for the next couple of years. The prospect of a recession, and a sharp movement upward in interest rates/capitalization rates makes the picture that much murkier—at a time when the resultant decline in transactions is hampering price discovery. Office real estate is highly cyclical at the best of times and was the last property type to recover from the 2007-2008 GFC. Weaker job growth and low office utilization could push the sector into a downturn that could take years to reverse, absent more robust employment gains and a significant uptick in office use.  

During this period of pricing expectations being reset, we expect the entire office real estate stock will face declines from rising rates and risk premia, as property-level cash flow comes under pressure. In general, we expect lower quality class B assets to suffer more value declines than class A properties do, given tenants' preference for higher-quality spaces with more amenities to entice workers to return to the office more frequently. Overall office values have tumbled roughly 25% since last year according to the latest Commercial Property Price Indices (CPPI) from real estate analytics firm Green Street, while public office REITs are trading at a steep 50% discount to net asset value (NAV). That said, it's difficult to pinpoint the drop in valuation given the dearth of transactions (CRE services firm CBRE Group reported a 71% drop in office transactions versus an average of 56% for all property types in the first quarter). We think valuation declines could vary greatly and are very asset-specific, based on the location and quality of the property, tenant roster, remaining lease term, and capital structure of the asset.

Recovery in the office sector could take years

While the broader CRE sector will feel the pain from a cyclical downturn and higher rates, the office sector will remain under more pressure for the next few years. The U.S. office vacancy rate hit a record high reaching almost 18% and we think vacancy could rise a bit further given the slow recovery in office utilization, particularly in gateway cities such as New York and San Francisco. Leasing volume remains below historical averages and net absorption is negative as supply outstripped demand in the first quarter of 2023. We'll need to see a pull back in supply and prospects of stronger job growth to lend some stability to the office sector but that could take several years.

Accessing capital will be challenging for the office sector in the near term. Bond spreads remain wide for office REIT and CMBS debt and we expect debt issuance for both REITs and CMBS debt to remain subdued. Banks have also pulled back from new CRE lending amid concerns about credit quality. In the first quarter, banks reported tightening standards for all types of CRE loans, according to the April Senior Loan Officer Survey. Such tightening was more widely reported by midsized banks than by either the largest or other banks. However, the tightening wasn't outsized compared with the previous quarter, before the turmoil in March. While banks pull back, we expect borrowers to seek alternative sources of funding. We expect life insurance companies to remain a source of capital for CRE borrowers. Life insurers will likely continue underwriting at a measured pace, as the growth of their commercial mortgage loan (CML) portfolios will be primarily dictated by the growth of their liabilities, which tends to be slow, and limited by their high underwriting standards.

While banks will be selective in lending given recent pressure on deposit outflows, lenders may not view foreclosing on CRE property as the best course of action if extending the terms of a CRE loan or restructuring the debt would offer better long-term prospects. As long as a CRE loan makes economic sense, lenders with balance sheet capacity would likely be willing to extend a loan. Foreclosure may be unavoidable in some cases, but widespread foreclosures are likely to generate a negative feedback loop, as fire sales and CRE losses could then hurt collateral valuations across the rest of a CRE portfolio and could result in a significant increase in criticized and non-performing assets.

Other Lenders Can Step Into The CRE Space

Private credit is one sector that may be able to pick up the slack if banks pull back. But the economics of the property in question would need to make sense. In addition, small bank CRE lending—should they pull back—may be more difficult to replace. That's because small banks use their expertise in their locale to compete more effectively than other types of lenders. The terms of these deals may not meet the credit standards of a larger lender who is not as familiar with the local community as a smaller bank. Also, the size of the loan may be too small to interest private credit, which of late has taken on larger loans. But private credit providers may be willing to partner with a smaller bank. For example, Blackstone has been talking to small banks about stepping in to lend alongside them as more look to slim down their balance sheets.

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

CMBS was once characterized by longer-term, fixed-rate financing. In the peak issuance years of 2006-2007, conduit deals—which were typically a mix of five-, seven-, and mostly 10-year fixed rate loans—accounted for almost 85% of transactions. Following the GFC, the market shifted—gradually, then rapidly, in the "CMBS 2.0" period. Indeed, shorter-term, single-borrower deals and CRE collateralized loan obligations (CLOs)—both mostly floating rate—made up nearly 80% of issuance in 2021-2022 (see chart 2).

Chart 2


Over that same period, the market has become more concentrated by loan size. This is not only because of the greater proportion of single-borrower deals, but also a consequence of conduit vintages from 2010-2023 averaging 36-73 loans compared with hundreds of loans pre-GFC. In addition, lending competition has largely eroded the presence of amortization in conduit deals, which means initial loan balances are very similar to those requiring refinancing or sale at maturity. These factors have increased the significance, and frequency, of refinancing risk in the sector.

While refinancing risk is certainly not new to CMBS, given that bullet maturities (which typically require a large payment at maturity) are common in the sector, the market now faces a much different set of circumstances than it did during the cycle of falling interest rates. The average coupon of new-issue office-backed conduit CMBS loans has increased considerably from recent lows, and is higher versus levels seen over the past five years (see chart 3)..

Chart 3


With coupons of 6.0%-8.0% in recent years replacing the 3.0%-5.0% of the past, and tighter lending conditions prevailing, refinancing risk has naturally risen. On the plus side, some market watchers think benchmark rates will stabilize and then decrease from current levels in the next few years—but the timing is important (if this happens at all). For struggling property types and properties unlikely to be able 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.

With that in mind, our analysis of market data and our rated book to explore the CMBS maturity profile by property type over the next few years shows that the outstanding balance of private-label CMBS (excluding CRE CLOs) is approximately $605 billion (as of March 31). This represents roughly 12% of all outstanding debt on commercial and multifamily assets when including owner-occupied and construction loans. Conduits account for a larger share of outstanding private-label CMBS debt. However, single-asset, single-borrower (SASB) loans have come to dominate issuance in the past few years, suggesting we might soon see parity in terms of debt outstanding (see chart 4).

Chart 4


Looking at the breakdown between property types, we note:

  • Loans backed by office assets account for the largest share for both conduits ($103.7 billion, or 28.8%) and SASBs ($63.3 billion, or 25.2%). However, while most SASB office assets weigh closer to class A quality, on average roughly half of conduit office loans (based on loan balance) are backed by class B assets.
  • Retail loans represent the second-largest group ($85.6 billion, or 24%) in conduits; however, they come in fourth for SASBs ($25.7 billion, or 10.2%). This makes sense as conduits aggregate large pools of smaller loans backed by retail assets such unanchored retail strip centers, while SASBs tend to be backed by larger loans on regional malls—a sector that has been challenged for some time.
  • Loans on lodging assets represent the second-largest group ($54.1 billion, or 21.5%) in SASBs; however, they come in fifth for conduits ($41.5 billion, or 11.5%). Large portfolios of lodging assets were the most common property type to be securitized in SASBs in the years leading up to the pandemic. Absent a major recession, the sector's strong post-pandemic recovery suggests it could gain more share both in conduits and SASBs in the years ahead.
  • Multifamily- and industrial-backed loans combined for 18.4% and 17.4% of SASBs and conduits, respectively. Given their favorable fundamentals relative to office and segments of retail, it's reasonable to assume their share of CMBS will continue to grow. 

Looking at loan-maturity profiles for CMBS broken out by all outstanding private-label (non-agency) conduits and private-label conduits we rate, we note the following:

  • For the overall market profile, the amount of conduit loans maturing is largely rangebound for most years from $35 billion-$50 billion (see chart 5). This year and 2030 are at the low end of the range at approximately $20 billion each—driven by, in the case of 2023, loans having already been paid off, and in the case of 2030, the fact that the onset of the pandemic in 2020 disrupted the market and reduced issuance.
  • For conduits we rate, loan maturities are weighted in the second half of the decade (see chart 6).
  • The property type composition of any given year of maturing loans generally reflects the broader conduit sector. In other words, office, retail, and lodging dominate most years.

Chart 5


Chart 6


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

  • SASB loan maturities peak in 2026-2027 (see chart 7). This is driven by the confluence of 10-year fixed-rate loans maturing along with shorter-duration floating rate. Note that fixed-rate SASBs were more common until 2018 before floaters came to dominate the sector. Though there are fewer SASBs maturity post-2027, most are older deals with fixed-rate terms of 10 years or more.
  • Unlike conduit loans, the maturity profile of S&P Global-rated SASB loans generally matches that of the overall market—albeit accounting for generally half of the aggregate dollar amount due each year (see chart 8).
  • The property-type composition here is also very similar to the conduit sector. Loans maturing each year are mostly lodging-, office-, and retail-backed assets. 

Chart 7


Chart 8


As shown, there are approximately $10 billion in conduit loan maturities for transactions we rate in 2023-2024. About 68% of the loans are backed by office (30%), retail (22%), and multifamily (16%) assets. Higher interest rates, combined with tighter financing conditions—made more challenging by the expectations that banks will pull back in extending credit—mean that the refinancing risk for loans coming due in the next 18 months is rising.

As a rough gauge to determine how maturing conduit loans may fare, we looked at each loan's most recent net operating income (NOI; as reported by structured finance information firm Trepp) and re-underwrote each one using its current balance, a 6.5% coupon, 30-year amortization schedule, and ran debt service coverage (DSC) ratio scenarios at 1.25x and 1.50x thresholds. We excluded any loans with properties that were already fully defeased, had recently reported NOI figures that weren't full year, loans that were already flagged as delinquent, or had current reported DSC below 1x (see chart 9).

We found that: 

  • From a purely DSC-threshold perspective, multifamily loans appear to face the most difficulty refinancing. We note, however, that most of these loans (51 out of 55) would meet or surpass a 1.25x threshold and that a few relatively larger loans were pulling down the sector's overall pass rates. Also, multifamily loans are historically underwritten to lower going-in coverages relative to other property types.
  • Retail loans exhibited the second-most in terms of challenges. Roughly 88.5% of loans maturing in either 2023 or 2024 would be able to refinance their existing debt loads at a 1.25x threshold.
  • Lodging loans performed best, with 96.3% able to meet or surpass a 1.25x threshold. We can assume their generally more conservative underwriting combined with recent strong performance were contributing factors.
  • Office loans performed relatively well, with 91.7% able to meet or surpass a 1.25x threshold. However, these assets benefit from longer leases and stable cash flows, so an assessment of any near-term lease rollover exposure would be warranted to thoroughly gauge refinance risk. 

Chart 9


All in all, we expect the refinancing picture to remain murky in the near term, especially within certain segments of office and retail. Under current economic and interest rate/financing conditions, it's likely a sizable portion of existing senior debt might not be refinanced prior to loan maturity, meaning special servicers' postures and actions will be key, especially in terms of granting loan modifications and/or extensions. We rate deals to legal final maturity, but we may take initial rating actions in the middle or lower end of capital structure to account for the risks that likely caused the need for a loan modification in the first place, depending on the situation. For our part, we have already taken a number of downward rating actions in the past 12 months, especially regarding single-borrower retail and, more recently, office transactions in which loans were showing varying magnitudes of stress. This trend will likely continue through year-end 2023.

Equity REITs

Tighter access to credit for the broader CRE sector will likely hamper the ability for REITs to access capital in the next year. While REITs only account for about 4% of the overall CRE debt outstanding of $6 trillion, they have carved out a niche within the CRE debt market as a regular issuer of unsecured bonds. We currently rate about $300 billion of debt issued by U.S. REITs. In addition to issuing unsecured bonds, REITs generally rely on bank lending (revolving credit facilities and unsecured term loans) for liquidity and other funding needs, though these bank facilities typically account for a much smaller part of the overall capital structure.

As a result, REITs tend to have limited exposure to floating-rate debt. A retrenchment from banks on CRE lending could hamper the ability for REITs to extend and maintain credit facilities at existing sizes and terms. Investor sentiment toward real estate has also turned more negative, given expected valuation pressures; this has caused widening bond spreads and equity prices to trade at steeper discounts to NAV estimates. Bond spreads have widened by more than 100 bps on average in the past year, and publicly listed REITs are trading at an average discount of approximately 20% to NAV. While year-to-date debt issuance has improved a bit with higher-rated companies such as Prologis Inc. (A/Stable/--) and Realty Income Corp. (A-/Stable/A-2) coming to market in the first quarter, we don't expect a significant recovery from last year's depressed levels. Access to capital for speculative-grade borrowers or those facing secular changes—such as the office sector—will likely remain constrained, given concerns regarding credit quality and valuation declines, and we expect many of these companies to turn to secured financing for their near-term funding or refinancing needs.

The REIT sector remains a largely investment-grade rated space, with about 80% of ratings at 'BBB' or higher. We currently maintain a negative bias on the sector with 16% of ratings having a negative outlook. Office REITs face significantly higher downgrade risk given about 50% of the office REITs have negative outlooks. A negative outlook indicates at least 30% change of a downgrade in the next one to two years.

Chart 10


Chart 11


Refinancing risk is significant but manageable for most rated REITs

U.S. REITs hold approximately $14 billion of debt maturing this year and $23 billion coming due in 2024—and the maturity walls expand in the following years (see chart 12). Despite tightening market conditions, we believe most REITs have manageable debt-maturity profiles. Most rated REITs proactively refinanced higher-coupon debt with lower-coupon issues in the past several years and maintain a good cushion in their debt coverage metrics, limiting downside risk.

Chart 12


However, borrowers with significant near-term debt maturities will likely face tighter and more expensive financing conditions, with refinancing options likely including secured funding, given the volatility in the bond market. We expect refinancing conditions to remain challenging at least until it's clear the Fed has finished hiking rates. REITs have generally improved their balance sheets since the GFC and operate with lower debt leverage and more unencumbered assets than they did prior. In our opinion, REITs have proven access to various sources of funding and can resort to alternatives to the unsecured bond market, such as term loans or private or secured debt (including CMBS), to refinance maturing debt and manage their borrowing costs.

We believe most rated U.S. REITs can absorb these rate increases, given that they hold a limited amount of floating-rate debt and have well-staggered maturities. There are only a few issuers whose proportion of variable-rate debt exceeds 25% of their total debt. Still, refinancing conditions have tightened, and we expect lenders to reduce loan-to-value (LTV) ratios; in some cases, landlords will be required to inject additional equity to facilitate the refinancing. Asset sales could be another source of funding for REITs, although we acknowledge transactions have been limited in the past six months and many property types are in price discovery. While we think high-quality assets remain attractive to buyers, sales of lower-quality assets could take longer to execute given the still wide bid-ask spread.

We view REITs' liquidity as adequate to strong, with sufficient capacity under their committed revolving credit facilities. We expect REITs to maintain access to these credit facilities as covenant cushions remain adequate. Still, we're observing cases in which issuers obtained waivers as covenant cushion narrowed amid weaker cash flow performance, and limited cases where a covenant breach limits the ability to incur additional borrowing.

Office REITs face higher refinancing risk as secular changes pressure demand

We have a strong negative outlook bias on the office REIT sector—about half of rated REITs have either a negative outlook or on CreditWatch with negative implications. We expect office assets to underperform other property types through the next two years amid the pressures on rents and occupancy levels. Growth for rated office REITs will likely be pressured, with flat to modest declines in same-property NOI in the next two years, given our expectation for leasing activity to remain slow and office landlords' limited power to raise rents.

Office REITs also operate with higher debt leverage and have more exposure to development than other REIT subsectors. Given the challenging landscape for office REITs, refinancing risk is elevated. Aggregate maturities for our rated office REITs are well laddered and face significant debt maturities in the next two years. Approximately $4.1 billion is set to mature this year, and $3.7 billion is due in 2024 (as of year-end 2022), representing 6.9% and 6.4% of office debt maturities, respectively.

We believe REITs that own higher-quality assets will outperform the overall market, with support from diversified tenant bases and long-term leases in prime locations that remain attractive to prospective buyers. While the U.S. office vacancy reached a peak of 18% in the first quarter of 2023, rated office REITs enjoy lower vacancy rates, with occupancy around 90% on average. We expect a widening bifurcation between class A and B properties, and we expect this flight to quality to limit occupancy declines as the sector undergoes structural changes under the increasing hybrid working models. Office REITs also maintain a largely encumbered asset base that could seek to refinance with secured debt as an option. Like other REITs, asset sales or selling of minority interests through joint ventures are also possible options.

Capital structures could weaken with an increase in secured debt 

REITs' unencumbered asset pools provide an important source of financial flexibility. In addition, unsecured bonds issued by REITs are generally protected by a set of bond covenants that are more stringent than for other investment-grade corporate sectors. Given relatively stable cash flows—with support from longer-term lease agreements and bond-covenant protections—the default rate has been extremely low compared with the broader corporate sector. Since the GFC, REITs have operated with lower debt leverage and further unencumbered their balance sheets. We expect office REITs in particular to increase their use of secured debt, given how wide their bonds are trading relative to U.S. Treasuries and other REIT property types. This added exposure to secured debt could put holders of unsecured debt at a relative disadvantage and could result in REITs breaching the notching threshold for unsecured debt (35% of secured debt/total assets for U.S. GAAP filers and 40% for IFRS filers). Additionally, speculative-grade borrowers could face recovery ratings pressure as a higher level of priority debt weakens recovery prospects for unsecured bondholders.

Lower valuations and higher mortgage debt could prompt more REIT landlords to default on property-level, nonrecourse debt when refinancing. For the REIT sector, we generally view this activity as portfolio management and don't consider it to be a default by the parent given the nonrecourse nature of the debt. In the real estate sector, companies regularly walk away from the debt of underperforming properties. This occurred in mall properties with some frequency in 2020-2021, and even some class A mall owners exercised this option. In the past several months, we have seen some office properties being returned to servicers, and we expect continued modest defaults on property-level, nonrecourse debt in the next two years. However, given the large and diversified portfolio of assets that our rated REITs own and operate, these actions generally don't have a meaningful effect on overall cash flows. 

Higher financing costs will pressure credit metrics and hinder growth

Given the rapid rise of borrowing costs, we expect coverage metrics to deteriorate as REITs refinance their low-coupon debt at materially higher rates. We also expect earnings growth will slow down amid the weaker economic landscape, adding modest pressure to cash flows and resulting in slow recovery of total debt to EBITDA (charts below). Across rated REITs, we expect rental housing and industrial assets to remain resilient, while office will likely face weak demand for a longer time period. We expect the pace of negative rating actions to increase, given that 15% of ratings have negative outlooks, compared with 3% with positive outlooks. The office sector has the highest negative bias, as six of the 11 ratings have negative outlooks or are on CreditWatch negative. 

Chart 13


Chart 14


Mortgage REITs

We expect higher interest rates will add to CRE market woes, contributing to higher capitalization rates and lower property valuations, particularly affecting CRE lenders with exposure to offices, retail malls, and hotels. Hence, we expect asset quality to deteriorate somewhat as the economic environment creates challenges for borrowers in the next few years—likely meaning a rise in nonaccruals and loan-loss reserves.

So far this year, of the six CRE lenders we rate, we have downgraded KKR Real Estate Finance Trust Inc. (B+/Stable/--) one notch and revised our outlook on Blackstone Mortgage Trust Inc. (BB-/Negative/--) and Claros Mortgage Trust Inc. (B+/Negative/--), reflecting higher leverage and deteriorating asset quality

The commercial mortgage REITs we rate focus primarily on transitional CRE loans, exposing them to the historically cyclical and volatile markets (see chart 15). These lenders mostly focus on transitional properties and—to a lesser extent--construction loans, both of which typically carry more risk than loans on stabilized properties. Transitional properties generally aren't fully leased and are undergoing improvements or being repositioned. Transitional loans are typically three years in duration and often have two one-year extension options. At the end of the first quarter, most transitional CRE loan portfolios consisted of post-COVID originations and were primarily in the multifamily sector.

Chart 15


While CRE lenders have scaled back on originating office loans, particularly for class B and class C office properties, they aren't immune to the ongoing risks related to transitional office loans. We are starting to see asset quality weaken as more loans—primarily office deals—migrate to higher internal risk ratings and lenders build up credit reserves. The secular change in the office sector is particularly notable in densely populated cities such as New York, Washington, D.C., and San Francisco. We remain concerned about credit deterioration, as it could lead to foreclosures or create the need for liquidity to meet potential margin calls. As of March 31, 2023, Blackstone Mortgage Trust Inc. (BB-/Negative/--) had the highest exposure to office loans among publicly rated peers at over 35% of portfolio (see chart 16).

Chart 16


We believe CRE lenders with hotel exposure in central business districts could also face headwinds, as business travel hasn't returned to pre-pandemic levels. ARI has the highest hotel exposure, with 23% of the portfolio at the end of last year, followed by CMTG at 20%.

Negligible debt maturities through next year

The CRE lenders we rate depend on secured financing in the form of repurchase facilities, CLOs, and term loans (see chart 17). Given higher capitalization rates and lower property values, the risk of margin calls related to repurchase facilities has increased. While some facilities allow for collateral to be marked based on market interest rates and credit spreads, many others only allow for marks based on credit valuation adjustment events. In the past two years, many companies have negotiated margin-call holidays and made these facilities non-mark-to-market, which reduces the risk of margin calls. Somewhat mitigating this risk are lower LTVs on these loans, which should be able to absorb the price impact. Over the next year it will be critical to watch CRE lenders' exposures to margin calls and their ability to tap public markets for liquidity.

Chart 17


The funding mix includes modest amount of corporate debt, but CRE lenders took advantage of low interest rates and tighter credit spreads in 2020-2021 to push out debt maturities. As a result, these companies have minor refinancing risk in 2023-2025 related to their corporate debt before hitting the peak of about $2.2 billion in 2026 (see chart 18). 

Chart 18


Many rated CRE companies reduced their exposure to and became less reliant on repurchase facilities in the wake of the pandemic. We believe this and the larger amount of unsecured funding are credit positives.

Banks And Insurers Remain Key CRE Lenders

The effect of bank sector turmoil on CRE lending

In the wake of the failures of three sizable U.S. banks, sentiment in the banking industry remains somewhat fragile. Although first-quarter results held up well for most banks, with deposit outflows moderating, funding costs are on the rise. Systemwide deposits declined about 2.5% in the quarter, but the deposit outflow has been more significant for midsize and smaller banks. In addition, banks are needing to increase deposit rates to stem outflows. Going forward this should negatively affect profitability and most banks will likely be more selective in terms of lending as they look to preserve liquidity and capital.

Besides balance sheet concerns, banks have also pulled back from new CRE lending because of concern about pending credit quality issues. According to the April 2023 Senior Loan Officer Opinion Survey, in the first quarter of 2023, banks reported tightening standards for all types of CRE loans. Such tightening was more widely reported by mid-sized banks than by the largest or other banks. However, the tightening was not outsized compared with the previous quarter, before the March bank turmoil.

Chart 19


Large bank versus small bank lending capacity and exposure to CRE

Larger banks seem to have more capacity to fund CRE loans than smaller banks. According to our analysis, the largest banks (more than $50 billion) hold about 45% of systemwide bank CRE loans. These banks had a loan to deposit ratio of 59% at the end of the first quarter versus 58% at the end of the fourth quarter and based on recent deposit trends seem to have the capacity to continue to extend CRE loans assuming the loans make economic sense.

Smaller banks with (less than $50 billion in assets), represent 55% of CRE loans are not as well placed as the larger banks. Their loans to deposit were 80% at the end of first quarter versus 79% at the end of fourth-quarter 2022. When looking at securities and loans to deposits, the ratio gets tighter. Said another way, these banks could have funding issues sooner than the large banks if they grow their loans quickly.

Chart 20


Different size banks have different exposures to CRE as a percentage of loans with the smaller banks having the largest percentage of CRE loans to total loans (see table 1)

We estimate that for the banks we rate, the median exposure to CRE (including owner occupied) is roughly 20% of loans and office loans are approximately 20%-25% of CRE loans at the median. A portion of the banks we rate, particularly smaller regional banks and those with specialty CRE product lines, tend to have the highest CRE concentrations.

Table 1

Banks' percentage of CRE loans
Construction Multifamily Non-Owner Farm CRE Not Secured by RE Total CRE
Large banks (> $100B) 1.8 3.6 4.8 0.1 2.4 12.8
Midsize banks ($10-$100B) 7.5 7.0 17.0 0.7 1.1 33.2
Small banks (< $10B) 8.0 7.3 18.5 3.9 0.4 38.1
Data as of March 31, 2023, and excludes owner occupied. Source: S&P Global Ratings.

The Credit Implications Of CRE Refinancing For Banks

Excluding owner occupied loans, according to Fed data, total CRE bank loans outstanding total roughly $2.5 trillion. We estimate roughly 15%-30% of the CRE loans outstanding for our rated U.S. banks are due to be refinanced this year. As the pipeline for refinancing comes due, banks criticized loans (a loan is criticized if it has an elevated chance of default) are likely to rise but not necessarily charge offs as this will depend on the ultimate valuation of a distressed property and the LTV at origination.

In general, when a loan comes due for refinancing, the bank that owns the loan will assess the value of the property and determine whether additional equity or mezzanine financing is required from the owner of the property (typically the sponsor) to help protect the bank in case the owner of the property defaults. If the loan is fixed rate, refinancing could pressure the economics of the property because the offering rate will likely be significantly higher than when the loan was first taken out. But even some CRE loans that have a variable rate could pressure borrowers when it comes due for refinancing. That's because some lenders of variable-rate debt require borrowers to buy an interest-rate cap that limits their exposure to rising rates.  In any event the sponsor may look to replace the financing if better terms can be found elsewhere. If there are no alternatives, the sponsor can either:

  • Try to negotiate better terms with the bank in an attempt to limit the additional capital needed; or
  • Walk away from the property if the sponsor believes the economic value of the property has been impaired such that a further equity investment is unwarranted. In this case the sponsor is willing to lose its initial investment.

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. With funding costs rising, banks will do their best to maintain 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.

Foreclosure may be unavoidable in some cases. However, widespread foreclosures could lead to fire sales and CRE losses, which could then affect the collateral valuations across the rest of their CRE portfolio, and could result in a significant increase in criticized and nonperforming assets. Expectations on interest rates could also provide an incentive for a bank to consider forbearance (such as extending a CRE loan) in lieu of foreclosure, since a future decline in interest rates could alleviate credit pressures.

We believe many bank CRE loans will likely be restructured. We capture restructured loans as part of our credit analysis as we look at nonperforming assets inclusive of troubled debt restructuring and gauge loan loss reserves accordingly.

CRE credit quality for banks

Delinquencies and charge offs for CRE owner-occupied loans have remained low so far. That said, the delinquency rate on nonowner-occupied, nonresidential property loans has increased for the past three quarters, with the 24-bp rise in the March quarter being the largest sequentially since the 20-basis-point rise in the fourth quarter of 2020. Although delinquencies for nonowner-occupied properties have ticked up, the levels are still not troubling. This is likely owing to the slow-moving CRE price discovery combined with many property owners still paying relatively low interest rates for outstanding loans on the property. As price discovery progresses and loans refinance to higher rates, we expect more significant CRE write-offs to materialize, over the next two years.

Chart 21


We performed a sensitivity analysis to determine the banking industry's ability to handle more significant CRE losses. Excluding owner-occupied CRE loans, which typically perform better than other types, there is roughly $2.5 trillion of bank CRE loans outstanding, versus roughly $2.0 trillion of tier 1 capital. A CRE loss rate of 10% equates to a loss of 12% of bank industry capital (see chart 22). In our view, a 10% CRE loss rate, assuming no other asset class is under significant stress, should be manageable for rated banks without heavy CRE exposure, especially since they could absorb some of those losses with preprovision revenue. That said, a significant rise in CRE losses could lead to heightened confidence sensitivity and deposit outflows. If we applied the same stress to just the banks in our rated portfolio with over 30% CRE exposure, a 10% loss rate would equate to 29% of capital, versus 12% for all banks, a much more significant hit and could lead to downgrades for some.

Chart 22


Insurers and CRE

At the start of the year, the total exposure of U.S. insurance companies to CRE across real estate equity, CMBS, and CMLs totaled $941 billion, the vast majority of which was held by U.S. life insurers (see charts 23 and 24 below). Insurers are buy-and-hold investors and generally have tight asset-liability matching policies that tend to limit the effects that rising or falling interest rates have on their business, despite the market-value volatility of their investments, including CRE. Life insurers have long-dated liabilities that match well against the long-term nature of CRE

Chart 23


Chart 24


Insurers tend to focus on high-credit-quality CMBS and CMLs to reduce the capital requirements that lower credit-quality investments introduce. About 90% of all CMBS holdings by U.S. insurers were in the 'AAA' or 'AA' categories to start the year, with only 2% below investment grade; life insurers' CMLs were also conservatively underwritten, with generally low LTVs (see chart 25). The high credit quality of the CMLs held by U.S. life insurers has historically led to better performance, with lower delinquencies and lower losses, when compared with broader CRE markets, such as CMBS (see chart 26).

Over the past decade, U.S. life insurers have increased the allocation to CMLs in their portfolios, to 12.1% of total investments in 2022, from 9.4% in 2012. This growth is part of an ongoing trend in the life insurance industry to increase its investments in private debt and less liquid instruments. This trend was initially driven by the need for yield and a desire to collect an illiquidity premium when interest rates were low but is increasingly seen as a worthwhile strategy even as interest rates have climbed; CMLs fit the long-term nature of insurers' liabilities and can still provide the illiquidity premium above publicly traded corporate debt. Life insurers don't write many demand liabilities, and therefore can manage the reduced liquidity of their investment portfolios.

Chart 25


Chart 26


Chart 27


We don't expect life insurers to pull back from CML underwriting, but they won't be hitting the accelerator either. They will likely continue underwriting at a measured pace, as the growth of their CML portfolios will be primarily dictated by the growth of their liabilities, which tends to be slow, and limited by their high underwriting standards. However, we believe life insurers will continue tweaking the property-type allocations within their CML portfolios. In the past few years, insurers have gradually reduced their exposure to retail properties, and since 2020 have also been reducing their exposure to the office space. At the same time, they have increased the underwriting of mortgages on industrial and apartment/multifamily CRE. We expect this trend to continue, also at a measured pace, as insurers don't typically trade CMLs but rather tweak allocations slowly as mortgages mature and they make new investments.

This report does not constitute a rating action.

Primary Credit Analysts:Ana Lai, CFA, New York + 1 (212) 438 6895;
Senay Dawit, New York + 1 (212) 438 0132;
James M Manzi, CFA, Washington D.C. + 1 (202) 383 2028;
Carmi Margalit, CFA, New York + 1 (212) 438 2281;
Gaurav A Parikh, CFA, New York + 1 (212) 438 1131;
Stuart Plesser, New York + 1 (212) 438 6870;
Secondary Contacts:Blake Macdonald, Englewood + 1 303-721-4929;
Mark Jacobs, Englewood +1 3037214926;
Writer:Joe M Maguire, New York + 1 (212) 438 7507;

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