Predicting Distress in Commercial Real Estate

Eric Wilson


July 3, 2023

6 min read

Eric Wilson


July 3, 2023

5 min read

Recent headlines paint a gloomy picture of the real estate capital markets, spurred on by regional banking concerns that have come to the forefront. However, apart from the metaphorical iceberg that is the suburban office market, distress signals aren't yet visible. So, when and where will commercial real estate start feeling the pressure? The answer lies in an intricate web of factors, including asset class, quality, and location, along with broader liquidity issues like capital availability and desirability.

A Look Back: Lessons from History

Historical events can often serve as a roadmap for predicting future outcomes. One such crucial period is the Global Financial Crisis (GFC). Many tend to overlook the time it took for distress to infiltrate the wider market post-GFC. Bear Stearns crumbled in late 1Q 2008, followed by Lehman in late 3Q 2008. Meanwhile, delinquency rates on commercial bank loans secured by real estate were at 3.5% in 1Q 2008. This climbed to 4.9% by 3Q 2008 and peaked at 10.2% only in 1Q 2010, two years after Bear Stearns' downfall. Fast forward to 1Q 2023, the delinquency rate stands at a meager 1.2%—lower than any period leading up to the GFC.

Decoding Delinquencies: A Reliable Indicator

The health of underlying fundamentals and liquidity often reflect in delinquent or unpaid loans, making loan delinquencies a robust indicator of distress. If history is our guide, distress will likely surface a few quarters after delinquency rates start to climb.

Post-GFC, lucrative buying opportunities didn't manifest until late 2011 and early 2012, three to four years later. Most lenders took this time to resolve their delinquency and default issues and to reestablish themselves as active debt capital providers. Many transactions post-Lehman were cash-based due to the lack of available system leverage. The GFC led to Dodd-Frank reforms, which today have put lenders in a better position to withstand commercial real estate turbulence.

The Present Landscape

In recent quarters, we've noticed a significant retreat in new originations from commercial banks. This has been further exacerbated by prospective Dodd-Frank reforms aiming to establish additional safety nets for smaller banking institutions, avoiding the recent downfalls of Silicon Valley Bank and First Republic Bank.

Meanwhile, several debt funds have stepped in to fill the void, but their borrowing rates are not exactly affordable—often priced at 500 or more basis points over SOFR, leading to an all-in interest rate over 10%. If the Fed doesn't lower short-term interest rates and rents decline over the next year, additional stress could be placed on these products' borrowers upon refinance or sale.

Looking Ahead

The U.S. rental housing market, especially where new supply is being delivered, is buoyed by solid macro demand fundamentals. Consequently, it's improbable that both rents and the debt capital markets will remain suppressed for an extended period. It suggests that significant multifamily market distress is likely several quarters away and that the level of distress may not match the severity or duration of the post-GFC era.

While it's important to keep an eye on distress in the office sector, multifamily borrowers experiencing varying distress levels still have options with debt and equity sources. Real distress will only surface when those financing options evaporate and delinquency rates begin to rise.