Office loan trouble signal problems ahead for a US$650 billion bond market
[WASHINGTON] When three Seattle office buildings a short distance from Amazon.com's headquarters defaulted on US$135 million worth of commercial mortgage debt last month, it left bond investors who financed the properties facing a long and uncertain slog to claw back money.
The buildings, owned for years by developer Martin Selig, became the latest additions to a pile of soured business property loans that is now as large by some measures as it was during the pandemic.
'A lot of defaults during Covid are still not fully resolved, and loans that were modified or extended during the 2022 interest rate hikes are coming to roost,' said Karan Malhotra, head of structured credit trading at Monarch Alternative Capital. 'They need to be flushed out of the system, so we're likely to see re-defaulting and more loan sales.'
Higher interest rates, which caused borrowing costs to rise and values to fall, are driving the current problems. The toxic mix is filtering through to a US$650 billion market where commercial real estate loans get packaged into bonds of varying size and risk. One in 10 of the mortgages inside these securities is bad enough that troubleshooters called special servicers now oversee them, double the rate from two years ago, according to real estate data company Trepp.
Office buildings are the source of many of the problems, but with values still down 37 per cent from their peak and the market moribund there's no easy solution for the special servicers whose role is to maximize recoveries for bondholders.
More trouble looms. The share of offices bundled into the securities that are seriously late on mortgage payments recently reached the highest since the aftermath of the financial crisis era at close to 10 per cent, according to data compiled by JPMorgan Chase. It's since dropped back slightly. Defaults and foreclosures are also on the rise.
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Concerns about economic stagflation or recession are adding to the headwinds. Some US$177 billion worth of securitised office loans have yet to reach their final payment dates and recent market volatility makes it less likely that borrowers will be able to refinance mortgages at maturity, said Bank of America strategist Alan Todd.
'The number one question I got on the road' recently was 'how do tariffs impact commercial real estate?' Todd said. 'The answer is nobody knows. But if you consider the higher odds of lower growth, more volatility and higher inflation, it's probably not good.'
The three offices in Seattle exemplify the type of properties front and centre in the new crunch. The buildings lack the high-powered amenities that have become a draw for tenants, while the number of workers downtown during weekdays is still just 60 per cent of what it was in 2019 despite Amazon, a major occupier, ending its hybrid work policy earlier this year.
Factors like this playing out across the USA have made it difficult for property owners like Selig to generate enough money to repay debt. Martin Selig Real Estate didn't respond to requests for comment.
With some mortgages staying in special servicing for six years or longer, according to Todd, the potential hit from defaults takes time to filter through to the bondholders. One projection by JPMorgan strategists estimates future losses on office loans in CMBS that package multiple debts could approach 9 per cent of total value, twice the level expected for retail or lodging financings.
'It's loans on obsolete office buildings that are pushing delinquencies higher. It's far from clear if these will ever recover' the debt, said Lea Overby, a strategist at Barclays Plc.
The prolonged workouts may have an impact for the broader economy. A 2024 paper by researchers at the Federal Reserve Bank of New York found that 'extend and pretend' tactics increases financial fragility and 'fuel a rising wave of impaired loans in the future.'
For now, the tactic shows no signs of stopping. Amend and extends soared by nearly 100 per cent in the year to March 2025, reaching US$39.3 billion worth of mortgages, according to a recent post by data provider CREDiQ.
That also makes it more difficult to bet against the distress. During the long decline of US shopping malls starting in the 2000s, short bets by Carl Icahn and others using CMBS derivatives delivered merely middling returns because borrowers on the hook for bad loans kept finding ways to extend the debt.
Despite that history, some see an opportunity in the coming trouble. These investors argue that even if loans tied to a given set of properties are unaffordable – perhaps because they were underwritten at low interest rates – some of the buildings are high quality and in demand from occupiers.
'We're gearing up for the opportunity,' said Matt Weinstein, co-chief investment officer at structured credit and real estate investor Axonic Capital. 'As downgrades and new appraisals go through, there's going to be owners of loans and bonds that need to sell.' BLOOMBERG
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