US CMBS set for 'tug of war' as office foreclosures loom
'Extend and pretend' will end as maturity wall hits and senior tranche holders press for liquidation
Simmering stresses in office CMBS in the US are likely to boil over in the next six to 12 months as market participants expect a mass wave of foreclosures to materialise, forcing a reckoning between senior and junior noteholders.
As stress in the US commercial real estate sector has intensified over the last year, CMBS bondholders and borrowers have been on edge, with lenders largely happy to push out maturities rather than force liquidations of CRE loans — including those securitized in CMBS transactions. Yet these liquidations are likely to start soon as banks begin to write loans off and senior noteholders push for liquidations.
In its third-quarter earnings report released last week, Goldman Sachs said it had marked down its office sector-related commercial real estate exposure by approximately 50%, realising a net loss of $212m.
“It’s the beginning,” said Darren Wolberg, managing director at Oppenheimer & Co on a panel at IMN and FINN’s ABS East conference in Miami this week. “Banks usually don’t like to mark down losses, but they now have to, and when that spiral starts to go down, it’s going to go down big, and it’s going to go down hard.”
Panelists at the conference said that other large banks, including JP Morgan, have begun to sell their loans to office properties in an effort to minimise further losses.
“As the fundamentals deteriorate, more and more large banks start to realise that sometimes the best loss is the one that you can just take early on, rather than wait until later when things get worse,” Matt Reidy, director of CRE economics at Moody’s Analytics, told GlobalCapital. “There is still a chance that we enter recession, in which case the pain in the office sector will be even more acute than other sectors.
“That is definitely on everyone’s mind.”
Office CMBS, which was badly hit by the rise of remote and hybrid working that took off during the Covid-19 pandemic, has seen delinquencies start to tick up significantly since December. Yet most of the defaulted loans are still landing extensions from lenders.
The average US office vacancy rate reached a new high of 17.8% in September, and the office CMBS delinquency rate has been rising for nine months straight, hitting 5.07% at the end of September, according to CRE data provider Trepp.
But as the market reaches a consensus that CRE is in dire need of repricing, a wave of foreclosures will start hitting the market in the next six to 12 months, said Jodi Schwimmer, partner of Reed Smith.
“It’s like during the financial crisis when homeowners finally had to come to a realistic idea of what their homes [were] worth,” said Schwimmer. “The market must clear, you go through the wave of foreclosures, and then you get the reset.”
Pressure from seniors
Bondholders of the senior tranches are more likely to press for liquidations as they could see this as a path to better recoveries, bringing the so-called ‘extend and pretend’ game to an end.
“There is definitely a tug of war between what the senior classes want and what the subordinate classes want,” said Pasquale Cardone, founder of PC2, a CMBS investment firm. “Rates have moved so much that [senior tranche investors] see [their] bonds traded at discounted dollar prices, so we’ll see more pressure from them to liquidate the bond.
”They want to get their money back in par, and get a good return somewhere else.”
While senior noteholders would largely be made whole in a liquidation, given the protection built into CMBS structures, subordinated noteholders have an inherent desire to extend the loans for as long as they can.
This enables them to continue to receive interest payments, and potentially get a better recovery if the CRE market turns.
One heavily watched CMBS deal, the $308m BWAY 2025–1740 that is backed by an office building on 1740 Broadway in New York, has changed its servicer several times, with the senior tranche investors having lost patience amid deteriorating property performance and pressed for a sale of the notes. The triple-A tranche has been placed on an auction site, according to one sell-side research note.
Murky price discovery
The reset of the office CMBS sector is unlikely to be swift or smooth. Real valuations of CRE assets remain murky because of light transaction volumes, said Schwimmer.
“There’s no price transparency until they are changed hands,” he said. “Everyone knows that there is a huge gap between the borrowers and lenders, and they can’t seem to find a common ground to meet each other.”
As a result, the process will likely start with smaller-sized loans, said Cardone, so people can test the market and see if they can wait for better pricing for the bigger loans.
“Portfolios of larger loans also tend to have complex problems, so as loans get bigger, the buyer pool gets smaller, and the process takes a longer time,” said Cardone, “We had a position in a legacy deal that defaulted in the global financial crisis, and that didn’t actually liquidate till 2015.”
However, market participants are expecting greater clarity in six to 12 months as deals that hit the maturity wall must get a realistic mark to market.
“There's a whole lot of money sitting on the sidelines right now waiting for this to happen,” said Mary Beth Fisher, managing director at Santander, on a panel at ABS East. “All the so-called vulture funds will help reset the market like they did during the financial crisis.“