Tenants Beware: Commercial Real Estate Debt & Distress Climbs

In recent years, the hole of commercial real estate debt has gotten deeper and deeper. And no matter how many steps are taken forward, we just keep getting knocked further back.

Because while $8.6 billion of commercial real estate debt was resolved in the second quarter of 2024, the period saw $10.6 billion of new distress.

In total, in the second quarter of 2024, U.S. commercial property distress reached $94.2 billion, a $2.0 billion increase from the previous quarter, according to MSCI's Capital Trends US Distress Tracker. The property market with the average highest debt is the office sector.

And as demand continues to tank for office properties, the greater economy watches the situation nervously. Because a decline in transactions and the rise of refinancing through extend and pretend means the pile of loans is just getting big enough to topple over and threaten the stability of our banks.

Read on to learn how.

• A drop in pricing leads to a rise in distress
• Interest rates are compounding the crisis facing commercial real estate.
• The concentration of debt differs by property type and geography.

Distressed Debt in?Commercial Real Estate

With a trillion-dollar CMBS loan crisis coming due over the next two years, the situation is reaching a head with over $100 billion in current distress.?

Besides the whopping drop in office demand and foot-traffic in the wake of the pandemic, the crisis was compounded by various factors, including rising interest rates from the Federal Reserve.

High rates squeezed commercial property prices and affected liquidity in the market. As investors and tenants navigated these turbulent waters, the search for value and price discovery became paramount. As such, many distressed properties were sold at a significant discount.

This is because landlords, struggling to maintain occupancy and generate revenue, were forced to sell their properties for cents on the dollar, sometimes reaching a 90% discount. Read more about distressed real estate transactions.

?And this appears to be a trend that will only increase throughout the third quarter and fourth quarter of 2024. Lenders are taking note, and the debt, often assumed by banks, is creating whispers of a bailout situation.

Commercial Property Prices Tank

In the office market, the decline in average pricing for rents has been especially severe. Commercial property prices for office spaces have dropped by as much as 13% in some areas, exacerbating the already challenging conditions. And with occupancy rates under 50% in major metropolitan areas, prices may even drop more as those leases come due.

The steep downturn in property values and prices has also led to an increase in defaults on commercial mortgage-backed securities.

Now, for tenants, the challenge of navigating in the commercial property market is acute with foreclosure risk looming around every corner.

Again, aggressive interest rate hikes from the federal reserve have played a pivotal role in this cycle, pushing borrowing costs higher and reducing demand further for commercial property development. As a result, property values have fallen dramatically, leading to widespread distress and defaults among landlords.

"The value of real estate owned (REO) properties, or properties or assets that lenders have taken back through foreclosure, also ticked up. The cumulative total of REO in the second quarter of 2024 rose 13% from the prior quarter and jumped 46% from the same period a year ago."

?-GlobeSt

With increasing foreclosures and challenges in refinancing loans, the risk of default is estimated at 1 in 3 for commercial landlords.

Distress by Commercial Property Sector

The commercial property sector continues to face potential risks across various asset classes, including retail, industrial, and multifamily.?

As 2023 ended, the commercial real estate sector was still challenged by the office and retail markets.

Offices accounted for 41% of the total value of distressed assets.

Retail also saw a sharp increase in distress in the fourth quarter, reversing an earlier trend where resolutions had surpassed new troubles.?

Potential distress, signaling the likelihood of future financial challenges, reached a staggering $234 billion by year-end. The multifamily market emerged as the largest segment of potentially distressed commercial properties, with assets valued at $ 67 billion, outpacing the office sector's $ 55 billion. But this probably has to do with how the extend and pretend phenomenon has obscured the true reality of distress in the office market.?

"The office sector notched its fourth consecutive distress rate increase and continued its status as the property type with the highest distress rate."

-GlobeSt

Where is the Distress Concentrated?

Interestingly, while the office sector dominated national distress figures, the apartment sector was the primary source of trouble among the property types, particularly in San Francisco.

It's no secret that San Francisco's commercial real estate market has been in a tailspin. Now rampant retail closures from high crime mean that there are more profound risks related to living in the area.

Beyond San Francisco, New York City's market boroughs also saw a significant portion of their cumulative distress stemming from the apartment sector.

"In the 10 markets with the most cumulative distress, the boroughs of New York City were the only other market where distress in the apartment sector, at 60% of the total, outweighed office sector distress."

-GlobeSt

Manhattan led the nation in overall distress, driven largely by the sheer volume of troubled office assets, which amounted to $41.0 billion. Meanwhile, retail properties contributed $21.8 billion to the total distress, while the apartment, hotel, and industrial sectors added $14.0 billion, $13.3 billion, and $1.7 billion, respectively. The geographical concentration of this distress is particularly notable.?

Takeaways for Tenants

Looking ahead, the industry faces a complex web of challenges and potential risks. The possibility of future interest rate cuts may offer some relief, but the road to recovery will require careful navigation of market dynamics, asset management, and strategic investments.

The downturn in commercial property prices was felt across regional markets, as property values fluctuated and the demand for certain property types declined.

New deals for tenants now require intense due diligence on their behalf. Any new lease should be thoroughly analyzed for rights and protections in the case of a landlord default. Access to tenant-preferred clauses like The Self-Help Clause and The Right of Offset could be critical to maintaining your bottom line should one of the landlords you lease from goes under.

It's also worth mentioning the power of leverage that corporations have when signing new CRE transactions. Prices for premium office space have never been so low. So, don't underestimate the value of market research and creating competition to get you a better deal in the long run. Whether this means lower rent or a more generous tenant improvement package, tenants have unprecedented negotiation power.

But before that can even be done, tenants must audit the financials of any new prospective landlord. You need to ensure that they can stay the course for a long-term lease.