Wall Street’s primary method of financing commercial real estate, commercial mortgage-backed securities (CMBS), has experienced a significant decline in 2023 due to higher interest rates and a slump in property values, according to a recent report by MarketWatch. With an estimated $2 trillion of debt coming due through 2024, borrowers are struggling to secure financing in a challenging market.
Deutsche Bank research indicates that CMBS issuance has dropped by 83 percent so far this year to $9 billion. While this accounts for only around 11 percent of the estimated $20.7 trillion commercial property market, CMBS serves as an essential indicator of the financial health of hotels, office buildings, apartment buildings, shopping malls, and other income-producing real estate.
Gabe Rivera, co-head of securitized products at PGIM Fixed Income, commented in the report, “Frankly, the machine is shut down. It’s not a great environment.” Interest rates have played a critical role in shaping market conditions for U.S. real estate, with borrowers previously able to take equity out of buildings based on record valuations when financing was cheaper in recent years. However, the recent surge in interest rates, with the Federal Reserve rapidly increasing rates by 500 percentage points in the past year, has made funding challenging for properties in need of financing.
Fed officials increased rates by another 25 basis points in early May, bringing the policy rate to a range of 5 percent-5.25 percent, the highest level since 2007. Fed Chairman Jerome Powell also reiterated that rate cuts are unlikely soon. “That puts pressure on valuations everywhere,” Rivera said. “There’s a whole face-off going on between borrowers and lenders, which is causing the machine to stop here.”
The stress in the commercial real estate market is further compounded by regional banks’ exposure to commercial real estate, which has been a source of angst since the failure of Silicon Valley Bank in March. Brett Ewing, chief market strategist of First Franklin Financial Services, thinks that the majority of big banks remain sound and resilient; he worries about continued fallout at regional banks. “I think it’s just the refusal by the Federal Reserve to acknowledge the regional banking crisis is actually accelerating, not decelerating,” he said in the MarketWatch report.
PGIM expects property prices to drop in a range of 7.5 percent-50 percent in this cycle, with office properties likely facing the most downside risk. Rivera also sees value in higher-quality commercial mortgage bonds, but expects price discovery to be a long and protracted process.
Despite his concerns, Ewing does not believe that the entire commercial property market should be viewed in the same way, especially over the long term. “Yes, there is a lot of carnage coming if you look at San Francisco’s office market,” he said. “But we do think that if you aren’t throwing the baby out with the bathwater that there’s a lot of value out there.”