Office Loans Are Toxic. Apartment Loans Could End Up Worse.
Distress rates are rising for a type of loan that apartment flippers feasted on during the pandemic
“Survive until 25” has become a mantra for landlords who are hanging onto buildings by their fingernails and praying for rate cuts soon. While it is well understood that many offices are a lost cause, apartment loans are in surprisingly bad shape, too.
More than $40 billion of office loans were in distress at the end of the second quarter based on data from MSCI, which is around three times the value of distressed apartment loans.
But the pool of apartment mortgages that could get into difficulty in the future is larger—$56.9 billion are at risk of distress, compared with $50.9 billion for offices. These loans are flashing amber because occupancy rates are falling or the income generated by the buildings is barely enough to meet interest payments, says Alexis Maltin, a vice president at MSCI Research.
One of the rockiest corners of the real-estate lending market is a niche product that apartment flippers gorged on during the pandemic. The distress rate on commercial real-estate collateralized loan obligations, or CRE CLOs, reached 10.8% in July, data released by CRED iQ on Monday show. This includes any loan 30 days delinquent, past its maturity or in special servicing where a third party tries to work out the best outcome for the troubled loan.
There is around $75 billion of CRE CLO debt outstanding, so it is a small part of overall lending. The debt is riskier than commercial mortgage-backed securities or bank mortgages, as they are floating-rate bridge loans for properties that need to be renovated before they can be leased out. As such, there is more uncertainty about where the rental income will ultimately settle and often a dose of wishful thinking in the loan underwriting.
Speculative property investors borrowed heavily from this part of the market during the pandemic to buy tired apartment blocks, particularly in the Sunbelt. Their plan was to fix them up, raise the rents and quickly flip the buildings for profit. CRE CLO loan issuance hit a record in 2021 at $45.4 billion when debt costs were exceptionally low and property valuations were at their peak. As most CLO loans are for three years, this vintage is now maturing.
Interest-rate cuts alone won’t bail out all these owners, as debt costs would need to fall very sharply to give them meaningful relief: In 2021, the secured overnight financing rate, which is typically used to price these floating-rate loans, was around 0.05% compared with 5.33% today.
And the properties aren’t bringing in as much cash as hoped. Strip out the impact of costlier debt and 46% of CRE CLO loans still aren’t generating the net operating income that was baked into the loan underwriting, based on an analysis by CRED iQ’s Chief Executive Officer Michael Haas.
Rent growth forecasts were too optimistic, and operating costs such as insurance have shot up. The apartment market has also become oversupplied. In 2024, 440,000 new units will be completed, pushing up vacancy rates and leaving rents flat at best in many markets, according to real-estate services firm CBRE Group.
Issuers of the CLOs are first on the hook for losses. To encourage sensible lending and avoid a repeat of what happened during the 2008-09 global financial crisis, when securitized subprime mortgages scorched investors, CLO originators keep some loan exposure on their own books, usually the riskiest tranches. Holders of the AAA-rated tranches of these CLOs look insulated though, because of how many others are in line for losses ahead of them.
The heaviest issuers of CRE CLOs in recent years include private lenders MF1 and Benefit Street Partners. Listed players Ready Capital and Arbor Realty Trust also lent billions and have attracted short sellers—38% of Arbor’s stock is on loan, a proxy for short interest.
Few apartment properties have gone into foreclosure yet, which is disappointing for opportunistic investors that hoped to pick up cheap assets in fire sales. Lenders are proving more flexible with apartment loans than offices.
This may be because they think that if the loans can limp along for a few more years, apartment rents should eventually start to rise again. A less charitable take is that CLO lenders at the bottom of the capital structure have so much to lose that they are doing everything possible to keep deeply troubled loans afloat.
A recession would be the final straw for some landlords. Consumers are showing signs of stress, with credit-card delinquencies at their highest levels in more than a decade. A tapped-out consumer doesn’t bode well for apartment owners that are waiting for the first opportunity to raise rents.
Offices will remain the big boogeyman for real-estate lenders, but there is pain on the way for apartments.