“Stay alive until ’26!” The current commercial real estate market mantra is popular for good reason. Higher-for-longer interest rates remain a dominant force and have had a significant effect on real estate valuations. At the same time, an estimated $1.5 trillion of commercial real estate debt is maturing over the next two years and more than $3 trillion is maturing through 2029, which could be the catalyst for stress turning into distress.
CMBS issuance is increasing. As of August 2024, U.S. private-label CMBS issuance for the year surpassed $69 billion, much higher than the full-year issuance in 2023 of $46 billion. The CMBS distress rate eased 11 basis points (bps) in August from July to 4.98%, but the delinquency rate climbed to 8.36%, an increase of 32 bps.
Spreads on fixed rate CMBS are tight relative to 2022 and 2023, driven by demand for fixed rate bonds from insurance company investors and institutions who view current rates favorably for asset/liability matching and long-term portfolios. Spreads on floating rate debt are wider, and more than half of this year’s SASB CMBS issuance was floating rate.
All-in rates on private senior CMBS are in the 6.40% to 6.85% range while benchmark rates are in the mid-3% range. The SOFR overnight rate currently sits at 4.59%, with the one-year SOFR SWAP rate at 4.32%.
If interest rates stay higher for longer, some owners needing to refinance over the next two years may turn the keys over to their lenders. Other sponsors may need to seek creative solutions to plug holes in the capital stack by issuing mezzanine debt or preferred equity. This additional capital is generally most available to owners that operate high-quality properties with good locations and desirable tenants.
In some cases, lenders are willing to relax original debt covenants (such as loan-to-value ratio), extend loan repayment schedules, assume equity, and participate in restructurings. According to the Mortgage Bankers Association, $270 billion in expected 2023 maturities were pushed back to 2024. However, because many bank lenders are constrained by capital adequacy ratios and overexposure to real estate, we’re finding that many capital stack restructurings involving additional equity, preferred equity, mezzanine financing, and CMBS issuance are becoming more common.
Recent high-profile transactions serve as examples of the restructuring activity happening across certain asset classes and markets.
Office: Liquidity Exists for the Right Assets Despite Significant Market Overhang
In its mid-2024 report, Cushman Wakefield predicted negative net absorption of 63 million square feet in the office sector in 2024 and 7 million square feet in 2025. As such, landlords face a long road ahead before the office market reaches stabilization in the latter part of the decade, at which time demand for new office space is expected to stabilize at about 20-25 million square feet per year. This suggests an overhang in the market for the next few years, during which some space will become obsolete, while some higher-tier property will require capital restructuring and refinancing.
277 Park Avenue Refinancing
$600 million refinancing of Manhattan office building at 277 Park Avenue
The sponsor had a $750 million CMBS loan on the property that was issued in 2014 and came due in August 2024. The building is nearly fully leased and situated near Grand Central station, a commuter hub. The new debt includes a $379 million A tranche, $109 million B tranche, $74 million C tranche, and $37 million junior bond. Investors insisted that $180 million of the funds go into a leasing reserve and $20 million into a debt service reserve. Additionally, the refinancing required a $250 million equity injection.
Importantly, 47.7% of the net rentable area is leased to a large national financial tenant, with 361,802 square feet expiring in 2026 and 536,319 square feet expiring in 2028. The tenant is not planning to renew its lease, so the fact that the deal got done shows there is still liquidity in the market for the right assets if well-structured.
Multifamily: Sponsors Plug the Gap with Preferred Equity
Multifamily performance varies by market, with the national vacancy rate sitting at 5.6% and rents increasing by 2% thus far in 2024, helped by lower new starts in 2024 than in 2023. However, the delinquency rate has increased from 1.91% at the beginning of the year to 3.30% in August. Furthermore, a significant amount of new supply is being delivered in 2024 and 2025.
Most multifamily construction loans are floating rate and offer a three-year initial term with optional extensions if the property meets minimum debt service ratio coverage and maximum LTV covenants, which may not be met in the current interest rate and leasing environment. Many of these properties will require an extension from their current lender, a refinance, or a restructuring of the capital stack.
Multifamily Financing
Preferred equity plugging the gap in multifamily project capital stacks across the US
In January 2024, a new multifamily development project in Florida raised approximately $15 million of preferred equity to plug the gap between common equity and the senior construction loan to complete the project. Another sponsor recently raised a preferred equity sleeve totaling 15% of the original mortgage balance to complete the acquisition of a two-property portfolio because loan proceeds and common equity were insufficient. In the Midwest, a multifamily development project tapped the preferred equity market to fund 14% of total project costs to plug the gap created by insufficient debt and common equity proceeds.
Capitalizing on Commercial Real Estate Market Turbulence
So, where are the current opportunities in commercial real estate, given high rates, expensive labor and supplies, and lower demand in some sectors? Looking across public and private markets and across all asset classes, we believe there are some interesting opportunities for discerning investors. Many of these are arising out of the need for developers and owners to restructure and refinance their capital stacks or cover shortages of capital needed for business plan completion.
For investors looking for opportunistic returns, we believe equity-like returns are possible while taking less risk at lower levels of the capital stack. We see compelling opportunities in the preferred equity space, with higher yields than debt and greater downside protection than pure equity. For those looking for consistent income with lower risk appetite, we believe there are interesting opportunities in the senior and mezzanine loan space, with ample opportunities readily available in the CMBS market.
The securities mentioned are for illustration purposes only. Under no circumstances does the information represent a recommendation to buy or sell the securities.
Across all opportunities, a thorough review of the sponsor, market conditions, and deal structure remain paramount; a thoughtful and disciplined approach can help in navigating this challenging, volatile environment. With pockets of the real estate market beginning to improve and capital stacks continuing to require refinancing or restructuring, the timing may be right to take a measured approach towards investment opportunities in the real estate sector across both private and publicly traded markets.
Opinion piece by David Bennett, director of Real Estate Investments at Thornburg Investment Management; Chris Battistini, senior fixed income analyst; Daniel Quinn, real estate investment associate, and Patrick Dempsey, fixed income analyst.
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