The once-bustling commercial property sector is facing a critical juncture, marked by a surge in foreclosures and property seizures. In the second quarter of 2024, the portfolios of foreclosed and seized office buildings, apartments, and other commercial properties climbed to an alarming $20.5 billion—a 13% increase from the previous quarter and the highest quarterly figure since 2015, according to MSCI. This uptick suggests the market’s punishing downturn is entering its next phase and approaching a bottom.
Interest Rates and Slow Office Returns Fuel Distress
High interest rates and the sluggish return of workers to office buildings have steadily built distress in the commercial property market to near historic levels. Many lenders, hopeful for a recovery and wary of the expenses and losses tied to foreclosure actions, had been reluctant to seize properties. "Lenders will do everything in their power to avoid that," noted Jade Rahmani, an analyst at Keefe, Bruyette & Woods. Yet, as the realization sets in that obsolete office buildings may not regain their former value even with potential interest rate cuts, lenders are becoming more decisive in seizing and selling distressed assets.
The Risk of Further Deterioration
A significant factor in this shift is the recognition that commercial property values could further deteriorate if the U.S. economy falls into recession, leading companies to downsize their office space requirements. However, historical trends indicate that surges in foreclosure activity often herald a market bottom. Once properties are seized, lenders are typically swift to sell, helping to establish new property values after extended periods of market stagnation.
Office Sector Faces the Brunt
The office sector remains the most troubled. MSCI reported that the volume of office property seizures rose by about $5 billion from the second quarter of 2023. Apartment buildings have also suffered, impacted by rising interest rates and a flood of new supply, with a $975 million increase in foreclosures during the same period.
Notable Distress Cases
Notable examples of distress include KKR Real Estate Finance Trust’s recent seizure of a five-building Silicon Valley complex from a Goldman Sachs and TMG Partners venture. Holding a $200 million mortgage on the property, KKR took title through a deed instead of a foreclosure transaction and plans to market the complex post upgrades.
In Washington, D.C., steeply discounted office building sales have compounded the challenges for lenders. State Farm Life Insurance, for instance, sold an office building near the White House for $17.6 million, more than 70% below its 2010 purchase price. "Lenders are more dispassionate about values and that’s a sign of a cycle moving toward a bottom," remarked Matt Pestronk, a developer who has acquired two discounted office buildings in the district for residential conversion.
Small Banks Increase Foreclosures
Small banks have particularly ramped up foreclosures. The total amount of seized commercial properties they owned jumped by about $125 million to $943 million in the first quarter—the largest increase since 2000, according to bank data consultant Matthew Anderson.
Prolonged Pain Ahead for the Industry
Despite signs of nearing a bottom, the commercial property industry is bracing for prolonged pain. Much hinges on the Federal Reserve’s actions regarding interest rates, with many anticipating cuts in the fall. However, rate cuts may offer little relief to landlords of obsolete office buildings, which might never recover their lost value. "Risk in commercial property will be with us for some time, probably for years," Federal Reserve Chairman Jerome Powell warned in a recent Senate testimony.
Regulatory Concerns and Financial System Risks
Regulatory concerns are also mounting. Distressed commercial real estate poses potential risks to the broader financial system, with more than $2.2 trillion in debt maturities due between this year and 2027, according to Trepp. The failure of Signature Bank last year, heavily exposed to commercial property, underscores these risks. Other banks, like First Foundation and New York Community Bancorp, have received large cash infusions to stabilize amidst rising commercial real-estate loan delinquencies.
Financial Sector Responses
The sector’s troubles are starkly reflected in the performance of Blackstone Mortgage Trust, which recently slashed its dividend and increased its loss reserves by 19% to over $900 million due to its high exposure to office loans. The delinquency rate for office loans converted into securities surged above 8% for the first time since November 2013.
A Changing Landscape
Although foreclosures remain below the peak levels seen during the 2008-09 financial crisis, the landscape has changed. Owners of obsolete office buildings today are more inclined to capitulate and walk away, recognizing that demand levels may never return. This has led to a rise in short sales and lender-involved property sales, which soared 83% in the first half of 2024 compared to the latter half of 2023, according to auctioneer Ten-X.
Nicholas Seidenberg, managing director at Eastdil Secured, aptly summed up the prevailing sentiment: "This cycle, many investors believe office values are challenged. They’re saying: ‘Hey, I’m going just to walk away and not fight.’"
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