In this episode of ‘The Inside Look,’ Senior Commercial Real Estate Economist Xander Snyder discusses the two major categories of distress, illiquidity and insolvency, and their unique implications.
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Transcript:
Hi, I'm Xander Snyder, and this is First American's Inside Look.
Commercial real estate is a credit-intensive business, which just means that debt is an important element in acquiring commercial properties. Interest rates, which are the cost of debt, impact commercial real estate in two major ways. First, higher interest rates decrease a building's profitability, since all else held equal, more money needs to be spent on interest expense. Second, higher interest rates can impact property prices, since the amount of borrowed money that a buyer can afford decreases as interest rates go up. Therefore, with higher interest rates, buyers can't afford to pay as much for buildings because they can't afford to borrow as much debt.
With interest rates much higher now than they were pre-pandemic, a good deal of attention is being paid on commercial real estate distress. However, not all distress is created equal. In fact, there are two major categories of distress: illiquidity and insolvency. And each comes with a unique set of considerations and implications. When both of these occur simultaneously, a building is at the greatest risk of facing a foreclosure.
Let's take a look at illiquidity first. Illiquidity occurs when a building is not generating enough income to cover its expenses. This is arguably the most pressing of the two types of distress, since if nothing is done to increase that property's cash flow, then the owner of the property could potentially run out of cash. Lack of liquidity means that a clock is ticking, and something needs to be done relatively quickly to fix that building's operations.
The second type of distress, insolvency, occurs when the value of a property falls below the outstanding balance of its mortgage. Colloquially, this is often referred to as a mortgage being underwater. Now, while there's still a time limit to fix insolvency issues, that time limit is generally a bit longer and is determined by the mortgage's maturity date. Because as long as a property can generate enough income to cover its daily expenses, then the owner can wait and hope for prices to recover, hopefully before that mortgage comes due.
Insolvency becomes an immediate problem when, at maturity date, the owner is either unable to fully refinance the outstanding balance of the mortgage or if the cost of the new mortgage, if the interest rate on the new mortgage, would create a liquidity shortfall post refinance. So when people talk about this looming maturity wall of commercial real estate mortgages, they're generally referring to this insolvency issue. But illiquidity and insolvency present unique challenges for owners and operators. Each trigger is necessary but insufficient on its own to force a foreclosure and it's worth bearing this distinction in mind.
Since the fundamentals of different asset classes vary meaningfully right now, the liquidity risks for each vary as well. By far the most at-risk asset class right now from a liquidity perspective is office, given the decreased demand for office space following the pandemic and the rise of remote work. According to data from Trepp, approximately 11% of office loans are illiquid, which means they can't fully meet their mortgage costs. This is the most of any asset class.
Now, insolvency is also a risk for office properties, but it is for other asset classes as well. According to a recent research report from the National Bureau of Economic Research, approximately 14% of all commercial mortgages are underwater, but approximately half of all office mortgages are currently underwater.
As more mortgages come due – and there's approximately $930 billion worth of commercial real estate mortgages coming due this year alone – insolvency will become a more immediate risk, especially for properties that have undergone price declines or are about to undergo price declines.
I'll be in Phoenix in mid-May to talk about the current state of the commercial real estate economy, and for how much longer this commercial real estate reset might go on for. If you're interested in attending, please reach out to your local First American representative.
Thanks for joining me on this edition of The Inside Look. We'll see you next time.