Assessing the State of Commercial Real Estate Debt

With investment sales activity in the commercial real estate sector still crawling at a snail’s pace and further interest rate increases looming, market observers are trying to figure out how well the industry is coping with current conditions.

A new report released last week by real estate research firm MSCI Real Assets offers some insights about what might be in store for commercial real estate investors looking for new loans or refinancing. The report offers some reassuring tidbits, as it seems debt continues to be available for most major property types, although at much tighter terms than in prior years. Refinancing activity is still trending above levels seen between 2015 and 2019, and lender losses on defaulted loans are averaging below what they were during that period.

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However, given that interest rates have not risen at such a rapid pace for over 40 years, there is still uncertainty in the market, especially on near-term loan maturities on loans secured by office buildings.

Here are some more takeaways from the report:

1. Total capital flows to U.S. commercial real estate, including investment sales transactions, refinancings and new construction starts, declined by about 38.6% in the first half of 2023 compared to the same period in 2022. Construction activity was the least affected by the decline, with new starts, at $171.4 billion, still above the average for the second quarter during the period between 2015 and 2019. Refinancing volume, at $284.8 billion, was also above that historical average, though it was down 35% compared to the first half of 2022.
2. Investment sales volume, on the other hand, continued to decline through August 2023, showing a 60% drop on a year-over-year basis, to $25.6 billion. Year-to-date in 2023, investment sales volume for all the property types tracked by MSCI Real Assets was down 58%, to $234 billion. MSCI researchers noted that it is important to keep in mind that investment sales volumes were unusually high in the first half of 2022, so some decline was a function of unfavorable comparisons. However, troubles in the regional bank sector earlier this year and the pullback from the market by some regional banks contributed to less financing being available for smaller deals in secondary and tertiary markets.
3. The apartment sector registered the steepest decline in sales volume in August, with a drop of 74% year-over-year, to $8.2 billion in sales, and a drop of 67% on a year-to-date comparison, to $74.6 billion. The office sector showed the second steepest drop, though from already low transaction volumes—down 64% in August, to $2.9 billion, and down 64% on a year-to-date comparison, to $31.6 billion.
4. At the same time, the RCA CPPI National All-Property Index, which measures property prices, declined by 9.9% compared to the same period in 2022. The price drop was again the highest in the apartment sector—down 14.9%—followed by the office sector, with a drop of 8.3%. The hotel sector was the only one to register a price increase, at 1.1%. However, most of the price declines occurred in the earlier part of the year. From July to August, commercial property prices fell by 0.5% on an annualized basis, MSCI researchers noted.
5. Distressed sales accounted for 1.8% of all commercial sales in the first half of this year, with losses on defaulted loans from the original loan amount averaging 19% across all five property classes MSCI tracks—up 600 basis points from average losses recorded in 2022. However, the figure was still significantly below the average lender loss of 28% recorded between 2015 and 2019.
6. There were 10% fewer loan originations made in the second quarter of this year compared to the average recorded for that quarter between 2015 and 2019. Originations for deals involving office buildings were down 52%, hotel originations were down 17% and retail originations down 15%. The only property sector to notch a substantial increase in loan originations in the second quarter was industrial, which at $17.2 billion in originations, was up 45% compared to the 2015-2019 period. The apartment sector, with $51.2 billion in originations, also registered an increase, albeit a much more modest one of 4%, at $51.2 billion.
7. Even for loans involving industrial and office properties, however, terms have been getting tighter. Loan-to-value (LTV) ratios on apartment loans declined by 510 basis points from their peak of 64.5% in 2021. LTVs on industrial loans were down 300 basis points. In addition, the interest rate on new commercial loan originations was up to 6.8% by the end of the second quarter of 2023, compared to rates in the sub-4% that were common in 2020 and 2021. It isn’t that financing was impossible to get, MSCI researchers wrote, it is that it can no longer be had at particularly cheap or easy terms. They also noted that for those borrowers looking to refinance long-term debt, the price growth their properties likely experienced between the loan’s origination date and the current period should provide some cushion against tighter lending conditions.
8. As a result of a tighter lending market and fewer lenders willing to underwrite new deals, the share of transactions involving seller financing jumped to 1.9% of all commercial real estate lending in the first half of 2023 from 0.5% of all originations in the first half of 2022. According to MSCI, during the Great Financial Crisis seller financing accounted for 4.6% of all commercial real estate originations.
9. When it comes to near-term loan maturities, as of August, more than $400 billion in commercial property loans set to mature in the second half of 2023 remained outstanding. Of those, about 40% were comprised of CMBS loans, 34% involved loans from banks of all sizes, 9% constituted investor-driven loans and 5% were CLO loans.
10. Approximately 20% of the loans scheduled to mature in the second half of this year are collateralized by office properties, with about three quarters of those loans being carried by CMBS and bank lenders.