There are two main causes of this mess and both are rooted in ill-judged government interventions.
When it comes to the troubled office market, the era in which “extending and pretending” and hoping for the best has been a (sort of) viable strategy is drawing to a close.
In this case, extending and pretending refers to giving a building owner that has borrowed to finance its acquisition of the property more time to repay that debt. The lender can avoid writing down the loan, the owner keeps the building. But, unless things turn up, such arrangements can only go on for a while.
Under the circumstances, this story from Bloomberg (May 23) made ominous reading:
For the first time since the financial crisis, investors in top-rated bonds backed by commercial real estate debt are getting hit with losses.
Buyers of the AAA portion of a $308 million note backed by the mortgage on the 1740 Broadway building in midtown Manhattan got less than three-quarters of their original investment back earlier this month after the loan was sold at a steep discount. It’s the first such loss of the post-crisis era, according to Barclays Plc. All five groups of lower ranking creditors were wiped out.
So, holders of the top-ranked (AAA-rated) slice of the debt took a 25 percent (or so) haircut, but at least they got something back. Junior creditors were wiped out. As is noted in the Bloomberg report, the fact that the losses reached the AAA level is a sign of how far the rot in the commercial real estate (which includes office property) market has gone. The building, once the Mutual of New York or MONY building, gave its name to that garage-rock classic, “Mony Mony” (which I note purely for the opportunity to mention that I once met Tommy James, the lead singer of the band that gave us that song).
But back to business. 1740 Broadway had one key tenant, L Brands (the parent of Victoria’s Secret and Bath & Bodyworks), which moved out in 2021. Blackstone had (Bloomberg reports) bought the building in 2014 for $605 million, financing it (in part) with a $308 million mortgage. As is the way of these things, this was sliced up into securitized pieces (CMBS — collateralized mortgage-backed securities) some or all of which were sold on to other investors. Blackstone refurbished the building to no effect (new tenants were elusive) and defaulted. 1740 Broadway has since been sold for $186 million (without any agreement to assume, I’d guess, any existing debt), yet another illustration of the dramatic collapse in office valuations: Over a period of ten years, 1740 Broadway’s price had fallen from $605 million to $186 million. And that’s by no means the worse sell-off the market has seen.
The (not very) bright side of all this is that the more distressed offices that are sold, the quicker that clearing prices can be established, and a fresh start be made. But arriving at those valuations will involve accepting substantial losses — a very painful process. The key question is how much damage that will do to the country’s banks, setting off shocks elsewhere through the economy. The conventional wisdom is that we are not facing a rerun of the financial crisis, but that does not mean that the banking sector will get off unscathed.
Meanwhile, via the Bloomberg report, some numbers:
The share of delinquent office loans packaged into a common type of commercial mortgage backed security reached 6.4% in April, the highest since June 2018, according to a report by Moody’s Ratings this month.
More than that, about $52 billion, or 31%, of all office loans in commercial mortgage bonds were in trouble in March, according to KBRA Analytics, up from 16% a year ago. The assessment includes both single-asset single-borrower and so-called conduit CMBS wherein mortgages are pooled together. Some cities are facing more stress than others, with 75% of CMBS office loans in Chicago and 65% in Denver in jeopardy, according to the firm.
There are two main causes of this mess and both are rooted in ill-judged government interventions. The first was the way that the prolonged Covid lockdowns changed the way that offices were used, and the second was the contribution made by central banks to keeping interest rates artificially low — depressing the price of money— for a decade or so.
Mispricing money for so long was bound to come with consequences, and some of them are bedeviling the office-property market for reasons best explained (as I have noted before) a few years ago by Thomas Hoenig, a former president of the Kansas City Fed:
An entire economic system. Around a zero rate. Not only in the U.S. but globally. It’s massive. Now, think of the adjustment process to a new equilibrium at a higher rate. Do you think it’s costless? Do you think that no one will suffer? Do you think there won’t be winners and losers? No way. You have taken your economy and your economic system, and you’ve moved it to an artificially low zero rate. You’ve had people making investments on that basis, people not making investments on that basis, people speculating in new activities, people speculating on derivatives around that, and now you’re going to adjust it back? Well, good luck. It isn’t going to be costless.
And so here we are.