At the end of Q4 2024, commercial real estate continued to exhibit severe weakness, with commercial real estate bonds hitting record distress levels, surpassing the previous records reached in Q3 2024. Commercial real estate bonds are just commercial real estate loans packaged into securities and sold to investors. One category of bonds, commercial mortgage-backed securities (“CMBS”), saw their distress rate increase to 10.6 percent, a fourth consecutive monthly record.
Most notably, in the CMBS category—which comprises approximately $625 billion in outstanding commercial real estate debt—loans on office properties now exhibit a distress rate above 17 percent while apartment loan distress accelerated to 12.5 percent. While loans underlying CMBS bonds—which are generally longer-term and fixed-rate—appear woefully insolvent, another group of bonds comprising short-term floating-rate commercial real estate loans are even worse.
These bridge loans—which are packaged up into CRE-CLO (commercial real estate-collateralized loan obligation) bonds—represent roughly $75 billion of outstanding commercial real estate debt today. At year-end, they were sporting a 13.8 percent distress rate, eclipsing the prior record of 13.1 percent set at the end of Q3 2024.
Worse than It Looks
As bad as the above stats may seem, they do not convey the true extent of malinvestment in commercial real estate, and the consequences thereof. For starters, the analysis leaves out the market for bank lending in commercial real estate—the largest source and the hardest for which to find data—comprising roughly $3 trillion in outstanding loans.
Simple distress rates also fail to recognize the potential for distress in nominally healthy loans, only identifying those that have explicitly been deemed distressed. In this case, distressed means 30 days or more delinquent on a payment, past the maturity date, currently in special servicing (a condition where property performance puts the health of a loan in jeopardy or specific loan agreement clauses have been violated), or a combination thereof.
A loan that is not currently distressed can nonetheless be potentially distressed and susceptible to losses once that distress is formally recognized. A recent analysis, published in a Wall Street Journal article, of distress in CRE-CLO bonds for apartments noted that 81 percent of such loans showed this potential distress.
Lastly, the distress rate is simply a measure of the loan balances considered distressed divided by all outstanding loan balances. As a metric, it does not convey the magnitude of losses in the event of default. This is critical, as it pertains to specific values by which these loans—and their corresponding bonds—must eventually be marked down. Once “marked to market,” these losses can have a significant impact on the financial statements of bond holders, comprising vast swaths of institutional investors—including banks—that must ultimately account for the true value of this $4 trillion asset class.
And therein lies the rub. Bondholders have not marked these investments down to their true value. Realizing losses on bonds reduces net income and balance sheet values for those bondholders. This, in turn, can affect perceived financial health, ability to raise capital, and—especially for banks—threaten compliance with regulatory requirements.
By avoiding marking down their bonds, they’ve been able to escape the ramifications for the time being. These bondholders can ignore reality, but they can’t ignore the consequences of ignoring reality. Ultimately, the truth will out. Bonds and loans require a certain amount of cash to support their contractual debt service requirements and, at some point, the fact that the loans do not generate enough cash will become unavoidably apparent. To see the matter clearly, a close look at the bond data—at the level of the underlying loans and properties—is required.
Anatomy of a CRE-CLO Bond
A randomly selected bond I reviewed comprises loans from 63 apartment properties with a total loan balance of approximately $1.7 billion. Upon review, it is immediately clear that this bond is insolvent. 15 of the 63 loans are currently delinquent to some degree and an additional 4 loans are not currently delinquent but have been delinquent at some point in the last 12 months.
The weighted average Debt Service Coverage Ratio (“DSCR”)—the ratio of net cash flow to debt service—for the entire bond is a lousy 0.54x. This means that the properties comprising the bond’s collateral produce only $54 in net cash flow for every $100 of debt service due. Remarkably, only one of the 63 loans has a DSCR above 1.0x. Recall that these are bridge loans, where debt service is interest-only. Unlike a residential mortgage, no principal is due with debt service payments.
Generally, as properties fail to produce the cash required to meet debt service payments, appraisals are performed to adjust values so that the reappraisal conforms to operational reality. Within this bond, however, only eight of the 63 properties have been reappraised. And of those eight re-appraisals, the average reduction in appraised value has been only 4 percent.
As an example, the property underlying the largest loan within this bond—a 500-unit apartment complex in a large western metro—was reappraised slightly downward in late 2024, from $105 million to $98 million, despite producing less than $3MM in net cash flow and carrying a DSCR of 0.36x. A proper market valuation on this property would likely land in the $50-60MM range, resulting in a $40-50MM loss on this single loan. A similar analysis of all loans within the bond would lead an analyst to suggest a significant impairment to its value.
Lipstick on a Pig
A review of various CRE-CLO and CMBS bonds, particularly those originating in the 2020-2022 period, paints a similar picture to what I’ve just described while offering additional insights.
Line items within the bond data often show loan-level DSCR markedly lower than that indicated by comparing the property’s net cash flow to the current debt service on the loan. This suggests an additional source of debt financing—aside from the loan in question—that is required to be included in the DSCR calculation but is not subject to detailed reporting within the bond data. This additional, mezzanine financing is provided to distressed borrowers by the bond managers and loan originators in order to temporarily cover current debt shortfalls on the main loan. This has the effect of keeping the loans out of formal delinquency but puts the borrower deeper in debt, exacerbating the existing problem.
Lenders and bond servicers have also offered many borrowers forbearance—including temporarily lowering interest rates or allowing cash interest to accrue—making loan and bond performance appear better than it would otherwise. Again, a temporary tactic that kicks the can down the road, doing nothing to address the fundamental problem of poor underlying property performance.
Appraisals and revaluations of the properties underlying the bond’s loans are also not being carried out honestly. This is because the admission of large reductions in property values would lead to the same for loan values, impacting bondholders directly, but also indirectly hurting adjacent entities and industries in a cascading effect. As losses on specific bonds are reported, those bondholders book losses on their own income statement. Equity is reduced on the balance sheet. For banks that hold such bonds, these movements imperil their compliance with regulatory standards. As these pieces of information become public, that cascading effect ripples out from a particular bond to other, similar bonds. Bondholders of all types are then viewed with scrutiny, raising questions about the health of the entire commercial real estate industry and every institution that has exposure to it.
Surprisingly, most or all of these types of bonds—including the specific bond described above—are rated investment-grade and “stable” by rating agencies.
If this sounds a lot like the subprime crisis of 2006-2008, that’s because there are many similarities.
At approximately $4 trillion, the commercial real estate loan market is the same size as the subprime mortgage market at its peak. Also like subprime loans, commercial real estate loans made over the last few years were issued in the midst of a raging bubble that saw prices reach unprecedented levels. To facilitate this bubble, loans were issued repeatedly to those who had no real experience in commercial real estate or investment management.
All of this was underpinned by the hysterical Federal Reserve and US government interventions during the covid panic, pushing monetary and fiscal madness upon the capital markets in the form of near-zero interest rates and trillions of newly-created dollars. The result is a burgeoning crisis in commercial real estate—which the data unmistakably confirms—despite attempts by bondholders to postpone reality.
