Brief Note: How Far Underwater is Real Estate?

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Is the much ballyhooed real-estate debt wall upon us? Will the markets and the banks all collapse in response?

For three years now the doomsayers have been predicting an utter collapse of prices for Commercial Real Estate (CRE), and sometimes also of most banks, as many underwater loans become due. Note that CRE includes much more than office properties.

The issue is that the owner may not find it sensible to provide enough equity to pay off the deficit and support refinancing at a lower principal amount. So the lender is facing a loss of principal, sometimes even total if the building has become obsolete.

The initial forecasts had 2023 as the year of the apocalypse. Since then we’ve had years of stories that lenders were kicking the can down the road, extending their due dates in the hope that conditions would improve. So the apocalypse was still coming, just delayed.

Lenders have steadily been addressing these loans, working out deals when they could and otherwise eating the loss. A friend who invests in these as an LP has experienced a number of total losses as properties were handed to lenders.

Today Globe St. author Philippa Maister, one of their better ones, has a summary of a recent report by MSCI. It lets us consider the actual, current scope of the problem.

There are $500B in CRE loans coming due this year. That’s out of $5.9 trillion of debt outstanding, per Trepp.

Per MSCI, at Q3 2024 price levels, about 14% of those loans are underwater. So less than 2% of total real estate debt is both due and underwater this year. I have trouble seeing the apocalypse in that number, or even a multiple of it to allow for the next few years.

Meanwhile we saw, years ago, a number of REITs express their ability and willingness to pounce on opportunities presented by distressed debt. More recently, Ric Campo, co-CEO of multifamily REIT Camden Property Trust (CPT) expressed that he now expects no big collapse in that sector. We also saw multiple billion-dollar funds announced with the same purpose, across more than just multifamily.

Even so, the amount of debt is not tiny and is weighing on some sectors. Summaries for a few of them follow.

Industrial

Alexis Maltin, executive director of MSCI’s America’s real estate assets research, noted that one issue can be the year they were built. “In the industrial sector, many assets built before 2010 have obsolescence and other fundamental problems,” she said.

I find this notable because to make any sense of pricing in the industrial REIT sector, you have to assume that rents will be paid for decades. If these are often assets that become depleted like oil wells or mines, then they ought to cost much less.

Multifamily

Overall about 10% of maturing loans are underwater in multifamily. Quoting Maister on this sector, “many of the apartments that are underwater have loans that were originated between 2020 and 2022 when the properties were marketed for record high prices and at very low mortgage rates that made them attractive to investors.”

These problem children are in large part located across the sunbelt. They tend to be concentrated in cities like Austin, TX, that have been growing like weeds. But demand has nearly kept up with supply in those places and we are not seeing a collapse in rents.

Again quoting Maltin, “It is not that there was anything fundamentally wrong with these assets, but that the underwriting was off base.”

Office

Office gets a large fraction of the press about CRE but is in fact a very small fraction of the total. That is where the biggest problems lie at present, with 30% of maturing loans underwater.

Still we have been seeing a big bifurcation in that market. Well-located, highly amenitized buildings are demanding very strong rents. Poorly-located, outdated buildings (Class B and C) will often end up being demolished.

Some investors will find great opportunities in this sector. One of them did recently, buying 135 W 50th St. in Manhattan from UBS for a song ($10M along with the assumption of a ground lease). That is a well-located class A building. I think they will get great returns.

Retail

Overall retail has been performing strongly, being underbuilt for more than a decade. This remains true even as retail bankruptcies are increasing, often reflecting unwise use of very cheap debt after the pandemic.

But shopping malls often remain challenged. Here again there is a bifurcation, with top-tier malls turning in great results. But changes in shopping behavior have increasingly made lower-tier malls less valuable.

Maltin reported that 80% of underwater retail loans are on malls. The long renormalization of that sector continues.

The Future

Between cost inflation and the impact of these debt issues, construction starts have fallen in all these sectors. As the economy continues to grow, the supply shortfall will in due course produce increased demand and improved prices for those properties.

Of course this is all local or regional. The impacts summarized above play out differently across the land.

The big takeaway from all this, in my eyes, is that the apocalyptic narrative is, once again, vastly overblown. Opportunities do and will remain for real estate investment even as this all plays out. Just be careful, as always.

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