U.S. Commercial Real Estate Market Going Through Dangerous Phase
It’s starting to look like there’s a perfect storm brewing in the U.S. commercial real estate market. The bigger the problems get, the higher the chances those problems could cause volatility in the financial markets and hurt the overall U.S. economy.
Before I go into the current details, here’s some history.
After the financial crisis of 2008–2009, the Federal Reserve did all it could to keep the financial system intact. It lowered interest rates to about zero percent and printed more money. That was seen as a heroic move, and was cheered on across the board.
Then, as the COVID-19 pandemic began in 2020, the Federal Reserve doubled down. This time, the Fed did a lot more in very little time. It again dropped interest rates to about zero and printed money at an extremely fast pace.
What did this do?
It made everyone complacent. Low interest rates and a high amount of money-printing made investors, businesses, and individuals feel invincible. They could borrow lots of money at next to no cost, and a belief prevailed that interest rates would remain low for a very long period. Things seemed great at the time, but it was a fundamentally flawed mentality.
Scary Amount of Complacency in U.S. Commercial Real Estate Market
When interest rates were low, complacency prevailed in the U.S. commercial real estate market.
According to data provider Trepp, interest-only loans as a share of new commercial mortgage-backed securities issuance skyrocketed to 88% in 2021, compared to 51% in 2013. (Source: “Interest-Only Loans Helped Commercial Property Boom. Now They’re Coming Due.” The Wall Street Journal, June 6, 2023.)
Essentially, with interest-only loans, the borrower pays interest for a term. The hope for the borrower is that they can refinance and pay off the interest-only loan and then get another loan.
When interest rates were low, these types of mortgages made sense, since the required payments were low. Landlords could take out interest-only loans and use excess cash for something else—and it made profits look stellar.
What’s the problem?
Trepp says $1.5 trillion in commercial mortgages are due in the next three years, and many landlords could be vulnerable to defaulting on their properties because of how these mortgages were structured.
Fitch Ratings, Inc. has an even more dire outlook.
The credit rating agency says that 35% of pooled securitized commercial mortgages that were due between April and December of this year will not be able to be refinanced, based on the properties’ current incomes and values, as well as the current interest rates.
Fitch Ratings says many mall and hotel owners are at a high risk of defaulting. Office building owners are in much worse financial shape.
Defaults have been rising lately. According to Trepp, securitized office loan delinquency jumped to four percent in May. This was up from 2.8% in April, and stands at its highest level since 2018.
What’s Ahead for U.S. Commercial Real Estate Market?
Dear reader, the reason I wanted to talk about the U.S. commercial real estate market was that it’s not something you hear about in the mainstream media on a regular basis. For the average investor, it’s one of the least interesting topics.
Here’s the thing, though: as conditions in the U.S. commercial real estate market get worse and interest rates go higher, many Americans will get a rude awakening.
There could be spillover effects.
Don’t get too fixated on building owners that default on their mortgages. Consider what will happen to all the creditors; they could lose the majority of their money. Banks could be on the line if they’re all-in on commercial property lending.
As the problems in the U.S. commercial real estate market get worse, they could have a negative impact on lending in the residential real estate market. If that becomes the case, it will create another set of problems.
There were already many risks that could hurt the financial markets, and you can add the U.S. commercial real estate market to the list. Things are getting worse, and they likely won’t end well. The U.S. commercial real estate market has the ability to cause a financial crisis and make the financial markets more volatile.