The industry has long postponed recognition of falling property values. The bill is coming due. Plus: a Seussian glossary.
In the dark days of 2022, when rising interest rates turned commercial real estate into a credit desert, the industry’s perpetual optimists found a rallying cry. Just survive until ’25, they told themselves. By then, inflation would be whipped, money would be cheaper, and demand would again tilt in their favor. But the wished-for salvation was wishful thinking. Borrowing costs remain stubbornly high, and lenders are running low on patience. As the new year approaches, the industry is bracing for the losses it’s been putting off. “I look at 2025 as a year of reckoning,” says Tim Mooney, head of real estate at Värde Partners, which invests in property debt. “Lenders and borrowers will acknowledge that lower interest rates aren’t going to save them.”
US delinquencies spiked in November, according to a Bloomberg analysis of commercial mortgage-backed security data, with more than 10% of loans on office buildings in arrears. Owners are running out of time to shore up funding, and some, like Cannon Hill Capital Partners and Pimco’s Columbia Property Trust, have already given in. The companies recently sold 799 Broadway in Lower Manhattan for $255 million, $15 million less than it needed to pay off its mortgage.
Commercial real estate has been running scared since the Covid-19 pandemic cleared out office buildings. Although early fears that lockdowns would ripple through the financial system proved off target, the rapid increase in interest rates in 2022 wreaked havoc across the industry.
Most real estate is financed with relatively short-term mortgages that require a large final payment. That’s typically covered by a new loan, but higher interest rates mean that refinancing a property can push payments higher than the cash generated from rents. And because assets are valued by the profits they yield, increased borrowing costs translate to lower valuations: an average decline of 23% for offices and 20% for residential buildings since 2022, according to data provider MSCI.
Lenders are less willing to refinance a building when its value falls, so many landlords have had trouble getting further credit when their loans mature. Banks don’t want the buildings either, so they kicked the can, giving borrowers more time to pay—a tactic industry wags call “extend and pretend,” which was perfected during the 2008 global financial crisis. Back then, valuations were hammered even harder, but with interest rates approaching zero, banks were willing to extend the loan term and pretend it wasn’t impaired. This time, with lenders in a stronger position, they’re often demanding concessions from borrowers, which banks sometimes call “amend and extend.”
A year ago, Brookfield Asset Management negotiated a 12-month extension on £459 million ($585 million) in loans for a London office building called Citypoint, agreeing to a one-off fee of almost £1 million and slightly higher monthly payments. So far, the extra time hasn’t helped Brookfield salvage the investment. It offered to sell the building in September for about £500 million—more than 10% below what it paid in 2016—according to people familiar with the effort. Bids are coming in much lower, the people say, requesting anonymity to discuss a private matter. Brookfield declined to comment.
Citypoint highlights another pressure: the spiraling cost of upgrading older buildings to boost their appeal to tenants and their employees. The longer borrowers and lenders delay, the greater the risk that tenants leave, further weighing on valuations. That’s been aggravated by rising construction costs, more demanding tenants and increasingly stringent environmental regulations. So owners need even more money to cover renovation if they want to refinance, or they take what they can get from buyers who’ll factor the higher costs into their offers.
Short seller Muddy Waters is betting on a decline in companies linked to commercial real estate. Barring an economic downturn that might spur a drastic cut in interest rates, it’s unlikely that delays will pay off for lenders, says Muddy Waters founder Carson Block. Instead, Block expects a second Trump administration to push inflationary policies such as tax cuts and tariffs. “I just don’t see how rates can come down that much more,” Block says.
The result is an impasse, with borrowers unable to pay off loans and lenders reluctant to take properties back. That’s effectively what happened at RXR’s Helmsley Building, a 35-story beaux arts office tower atop Manhattan’s Grand Central Terminal. The loan was flagged as problematic before it was due to mature in December 2023, though RXR got extra time to study a conversion of the building to apartments. That didn’t work out and lenders have moved to foreclose, though RXR says it’s still negotiating.
Pessimists say the industry’s inclination to delay and pray has made things worse. The volume of commercial real estate loans coming due in the five years from 2023 was equal to 40% of bank capital—more than double the level in 2020—according to the Federal Reserve Bank of New York. Worse, Fed researchers found, banks that are less well-capitalized are more likely to extend problem loans, presaging more woe ahead.
In Europe, regulators are pressuring banks to write down the value of their loans to account for lower valuations. Traditional lenders are better positioned to do so after higher interest rates have boosted their profits, says Jackie Ineke of wealth manager Spring Investments SA. In the US, watchdogs have been more lenient, but banks—especially smaller institutions—have leaned heavily into commercial mortgages and will eventually be forced to acknowledge the iffy loans on their books. “That’s where a lot of the problems lie,” Ineke says.
Barring a regulatory crackdown, any recognition of losses is likely to play out slowly. In an alternate scenario, central banks might suddenly slash interest rates, pushing valuations higher and granting the industry its long-awaited lifeline. But for now, each building sale or foreclosure provides the market with another data point, giving borrowers and lenders a better idea of the true market value of properties. In other words, putting the trouble off until 2025 didn’t fix the underlying issues, says Alex Killick, an asset manager at CWCapital. Even if most owners still can’t pay off their loans, Killick says, “liquidating into the abyss in late 2023 wasn’t the answer either.”
The industry has developed an evolving (and often rhyming) litany of tactics as it awaits better times. Here’s a quick guide:
Extend and Pretend
A popular tactic in the 2008 global financial crisis. Everyone agrees values are down, but they act as though they’re not. Rather than require borrowers to refinance maturing loans, lenders simply give them more time to come up with the money. Extend long enough, the theory goes, and maybe property values will recover.
Amend and Extend
Lenders are less desperate this time around, and they’re driving a slightly harder bargain. Rather than hand out extensions for free, banks force borrowers to fork over cash or agree to stricter loan covenants. The end result is similar: Repayments get pushed out.
Delay and Pray
A snarkier take on the same idea. Desperation is kicking in, and vulture investors hoping to buy distressed assets for pennies on the dollar start circling—and deriding what lenders insist on telling the public. Conventional wisdom is that there won’t be as much distress as there was in the wake of the global financial crisis. That doesn’t mean the vultures can’t hope.
Survive Till ’25
A popular mantra in recent years because the industry has anticipated falling mortgage rates and revived demand. Although central banks have started easing interest rates, the cost of borrowing hasn’t declined as much as many had hoped. So … how about “Get a fix in ’26”?
Payment-in-Kind
If you examine the changes being made to loans these days, it’s clear lenders know losses are on the way. Payment-in-kind is a form of financial engineering where borrowers stop making monthly payments, adding to what they must pony up when the loan matures.
A/B
Some lenders are splitting up their loans: There’s a safer A segment, with a lower interest rate, that gets paid back first. The riskier B portion, by contrast, offers a higher rate but has a lower chance of repayment.
Maturity Wall
Shifting the problems into the future adds to what’s known as a maturity wall: a pile of loans all coming due at once and in need of new financing, which risks gumming up the whole system. If a bunch of borrowers default in unison, banks won’t have sufficient capital to absorb the losses. That threatens a wave of fire sales, driving prices down even further.
Source: bloomberg.com
