Commercial real-estate’s debt machine is broken down
Wall Street’s main artery for financing commercial real estate has sputtered this year as higher interest rates and sagging property values darken the outlook for borrowers with an estimated $2 trillion of debt coming due through 2024.
Issuance of commercial mortgage-backed securities, or bonds sold by Wall Street banks to finance commercial buildings, has fallen by about 83% so far this year to $9 billion, according to Deutsche Bank research.
A grandmother's van life and where housing investors live: This week's top real estate stories – The Globe and Mail
Here are The Globe and Mail’s top housing and real estate stories this week, with the lowest mortgage rates available in Canada today, commentary from our mortgage expert and one home worth a look.
The housing crisis chose van life for this 57-year-old grandmother
Terri Smith-Fraser, a nursing assistant, was renovicted from her Halifax apartment last spring when the cost of rent for her two-bedroom apartment more than doubled. Unwilling to be a burden on her adult daughters or find a roommate, she decided van life – usually associated with the young and adventurous – was her only viable option. Suddenly a bronze 1998 GMC Savana purchased in January, 2022, was home.
“I’m a grandma. I’m not a 20-year-old nomad snowboarder. I’m just your regular person who goes to work every day, and I live in a van,” Ms. Smith-Fraser told The Globe and Mail.
Three reasons why mortgage refinances are disappearing
Mortgage refinances have fallen off a cliff. They’re down by 32 per cent, according to the latest data from the Canada Mortgage and Housing Corporation (CMHC). People still need to refinance, but there are three reasons why they can’t, Robert McLister writes in his column:
- Tumbling home values
- Soaring rates
- The stress test
And here’s what to do about it if you’re in this boat.
This week’s mortgage rates: Markets price in another dose of tough rate medicine
“Higher for longer” is again the buzzphrase in Canada’s rate market. So much for the mini-U.S. banking crisis, which drove rates lower for all of two months, McLister writes. Now we’re dealing with a U.S. debt ceiling mess and persistently disappointing inflation indicators, not the least of which is stubbornly low unemployment. Both those factors have been driving rates higher.
Four in five Ontario housing investors live in the province: Statscan
More than 80 per cent of individual home investors in Ontario live in the province, according to a new report from Statistics Canada. Just 3 per cent of individual home investors reside elsewhere in Canada and 16 per cent live outside of the country, reports Rachelle Younglai.
The story is the same in British Columbia, Manitoba, Nova Scotia and New Brunswick, which does not reflect the spike in investor buying that occurred during the COVID-19 real estate boom. The study provides a window into investor buying patterns, which have come under scrutiny as home prices and rents have soared across the country.
Home of the week: An urban manse on Toronto’s Humber River
From the street the home is an imposing two-storey stone manse at the top of a circular driveway with bay windows flanking the formal entrance. The foyer is a festival of detailed millwork and wainscotting that continues into the central hall and then into the formal rooms flanking the entrance. All of the doorways and windows in this space have modest arches, which adds a bit of Hobbit-like character.
The second floor has more of the original woodwork and arched windows, and the landing at the top of the stairs is generous enough for another formal sitting area with ravine views, and a balcony.
What do you think is the asking price for this house?
a. The asking price is $7.59-million.
LACKIE: Busy Spring in Toronto Real Estate – Toronto Sun
This has been a busy, bustling spring for the Toronto real estate market.
There are people who will say it’s all an illusion. A perfectly coordinated dance between snake oil selling realtors and their greedy clients, all unified in pumping a market currently back on its heels as means of personal enrichment.
How does that saying go — never let the truth get in the way of a good story?
They will say it makes no sense that the market should have any signs of life at all given the rollercoaster of the last 18 months (slash, the three years since COVID, if we’re being honest) and that with rates high and staying there, and prices still high and mostly staying there, we are looking at the furthest thing from a healthy marketplace.
And perhaps it’s all relative — things feel particularly energized because in comparison to last fall, we are actually seeing some action out there.
Houses in dodgy pockets fetching upwards of 20 offers, buyers seemingly undeterred by the needles on the street just steps away from the front door.
Cute houses in great pockets drawing multiple offers and landing peak-of-2022 prices.
LACKIE: Gap between haves and have-nots widens as gov’t shrugs
LACKIE: Make way for multiplexes Toronto
LACKIE: Blame the sellers, not just their agents
Sellers who may have wondered if the time-was-now realizing they didn’t want to miss their moment.
There are many utterly baffled that the market has held. That prices have held. That the pain of 2022 didn’t reset the playing field.
They are adamant that any attempt to explain it by pointing to how grossly insufficient our inventory levels are is really just distortion and manipulation. The idea somehow being that people can be scammed into engaging and thus what we are really looking at is a mirage.
They think our problems will be solved if buyers simply stay home. Refuse to show up to houses that are underlisted. Refuse to engage in multiple offers. Refuse to pay a dollar more than list price. Refuse to pay realtor fees. Refuse to participate.
Legislate agents into listing at market value. Legally obligate sellers to accept any offer that meets the price they chose to list at. Cap realtor fees. The list goes on.
Absent from all of this is the reality very much apparent on the ground: for all of the noise and anger, Toronto has not enough houses and more than enough willing participants who are capable of driving a marketplace.
By this time next week, we will have stats to support that the spring market is very much here and with it I expect we will note a sharp increase in transactions and a notable bump to average sale prices.
Is it a seasonal blip that will fizzle out as temperatures rise? Entirely possible. But even just a return to some seasonal rhythms in our marketplace would be a welcome return to normalcy.
Downtown real estate and commercial buildings are struggling. Why won't landlords lower the rent? – Slate
They call it the “debt wall,” and it is not the kind of wall that protects you. It’s the kind that might collapse and crush your village, or into which you might crash your car. Specifically, it is $1.5 trillion in commercial real estate debt, owed to banks, pension funds, and insurance companies before the end of 2025, and secured by a national portfolio of office, retail, industrial, and multifamily properties that may not be worth what they were five or 10 years ago when those loans got made.
The country’s downtown office buildings, as you may have heard, are in particularly dire shape. The return to the office has stalled, and many once-vibrant business districts have fallen on hard times. According to data from the brokerage Colliers, almost all of the biggest office buildings in downtown Los Angeles are underwater on their loans—meaning, their owners owe more to the bank than the buildings are currently worth. L.A.’s office towers have, on average, more than $230 in debt per square foot, Bloomberg’s John Gittelsohn reports, and the only building to sell this year went for $154 per square foot. That’s a lot of water. The city’s biggest commercial landlord, the Canadian property giant Brookfield, has defaulted on more than a billion dollars of loans this year.
I asked Tomasz Piskorski, a property market expert at Columbia Business School, why we should care if some downtown mogul—or better yet, the shareholders in a publicly traded Canadian office company—takes a haircut on their trophy building. For that matter, why should we care if they have to hand over the keys to the bank? He gave me three reasons: First, because city property taxes will decline with the value of their office districts, prompting the so-called “doom loop”—the downward double-helix of revenue-strapped public services and diminished urban activity, each worsening the other. Second, contagion from abandoned office buildings will spread to retail (no daytime shoppers), restaurants (no daytime diners), and street life (no happy hour!), draining the vitality of urban neighborhoods.
Third: Widespread defaults on loans backed by commercial real estate could prompt a crisis at shaky regional banks, prompting tighter credit, bank runs, and ultimately, a financial meltdown.
That last scenario, most experts I consulted said, seems unlikely to produce economic catastrophe. That’s for several reasons. For one, the key indicator of whether commercial property owners are failing to make their payments is down year over year, and more than 70 percent below its financial-crisis high. It is creeping up for office space in particular, but don’t let downtown’s struggles cloud your vision: Most office space is suburban, and most “commercial real estate” is not office space—it is also composed of medical offices and malls and warehouses and data centers and even multifamily buildings. Owners of those properties may have their own problems with rising interest rates, but their fundamental business remains sound.
Unfortunately, if you live in a city, you probably do have to care that some big office owners are getting killed on their downtown investments. But you don’t have to panic. In fact, downtown might have a bit further to fall before it can be effectively revitalized. Whether the future of downtown is spiffy, hybrid-work-friendly office space, more complicated uses like labs and biotech, or much-needed conversion to residential, it is only possible if owners and bankers give up on their old model, and their old valuation. Piskorski says: “We need more distress to get things moving.”
There are three separate reasons commercial real estate is being pummeled. First, it’s highly leveraged, or in plain English, landlords usually borrow most of the money they need to buy their properties. Second, interest rates have risen significantly, which means that getting a loan has become much more expensive than it was five years ago. Owners typically refinance the loans in that debt wall, but that’s going to be a pricy proposition this year. Selling is no easier; buyers will also have trouble borrowing money. Third, those rising interest rates are not associated with strong demand, as they have been in the past. As the situation in Los Angeles suggests, no one is sure how many people will want to rent downtown office space in the years to come, and corporations are cutting headcounts as well. This is, well, weird: Usually, an overheated economy with rising inflation would have lots of office demand! But pandemic habits are sticky.
To understand why things need to get worse for downtown office space before they can get better, it helps to understand the incentives facing both beleaguered property moguls and anxious lenders. First the lenders: They want to be paid back, of course. But if that’s not an option, they may not move immediately to repossess a half-empty, underwater skyscraper. A Great Recession–era rule designed to prevent bank failures allows lenders to give struggling borrowers a long leash if the bankers think they might one day get paid back. And they have good reason to “pretend and extend.” This lets them keep that big loan on the positive side of their balance sheet, even if they’re not getting interest payments. But this isn’t great for downtown, because the leniency leaves current owner-operators with little incentive to figure out how to bring their buildings back to life.
“Last time this happened, lenders took possession, sold it off, saw people who bought it for 20 cents on the dollar making lots of money,” said Richard Barkham, global chief economist at commercial real estate giant CBRE. “They’re not in a sufficiently stressed position that they need to initiate that.” For perspective, he added, the residential market during the Great Recession was worth $43 trillion. Today’s commercial market is $21 trillion, of which $7 trillion is office, with just a quarter of that seeing serious problems.
Foreclosure, meanwhile, can be worse for a bank than pretending and extending. It takes time and money, and requires telling your depositors and investors that a big chunk of money has been replaced by an abandoned edifice.
And that might be even worse for cities. “These buildings will go into a process that will make them no man’s land—untended, unwanted, unused,” says Susan Wachter, a professor of real estate and finance at the University of Pennsylvania’s Wharton School. “Banks are notoriously bad owners for making decisions. They’re not entrepreneurs and not in a position to actively manage buildings.”
When foreclosures rocked the nation’s single-family homes 15 years ago, the situation was a little different. Then, like now, owners had overpaid or gotten surprised by interest rates (in that case, variable rate mortgages), and wound up in trouble with banks. But as Aaron Glantz shows in his book Homewreckers, Wall Street investors knew the homes had value, and were more than happy to snap them up at auctions and begin to assemble the sizable portfolio of homes for rent that characterizes many Sun Belt cities today.
What’s happening now is something like the opposite. For one thing, the owners who are defaulting on their commercial real estate loans in 2023 aren’t struggling mom ’n’ pops—they’re big, institutional investors. And the buyers, as Jim Costello, chief economist for real assets at the financial firm MSCI, explained on the Odd Lots podcast recently, aren’t big firms. They’re local buyers with appetite for tough projects and relationships with local land-use regulators. “The folks who have been buying these properties so far are local developer-operator-owner types,” he said. “It’s people who know how to swing a hammer.”
What do things look like from the perspective of a skyscraper owner? Some of them have apparently reasoned that their credit can withstand a default or three. Others seem to be whistling past the empty desks. According to data from Kevin Auble, a research analyst at Cushman and Wakefield, office rents are up 27 percent in downtown Chicago since 2013, even as vacancy approaches 25 percent. In Manhattan and San Francisco, office rent is about where it was five years ago. In Seattle and Houston, office rents are slightly up in that timeframe. In all those cities, vacancy rates have climbed above 20 percent.
Why won’t landlords try to fill a few floors by asking for lower rent? It could be that new leases are mostly being signed at the high end, as corporate tenants seek out smaller, nicer spaces—a phenomenon dubbed the “flight to quality.” It’s also true that “effective rents,” which include concessions and handouts, have fallen more than the sticker price. And with high inflation, a steady asking rent is a real decline.
But if office rents aren’t as battered as the stock prices of publicly traded real estate investment trusts (REITs), it may also be because landlords are holding out for sunnier skies: an “option value.” Lease terms are 10 to 15 years, so if you drop your price, you’re making a long, bearish concession. A big rent drop may also trigger terms in a building loan that force you to refinance. And finally, if a landlord thinks renovation, adaptive reuse, or demolition might be the right move—even eventually—you don’t want some pesky new tenant in there gumming up the works.
Transactions of whole buildings have crashed, probably because sellers are in denial about prices. But maybe things are starting to change. Earlier this month, the Wall Street Journal ran down a list of recent, bargain-basement office sales. Those new, low valuations are going to hurt on cities’ tax assessments, but they free up buyers to do new things. The Journal cites investment manager Hines, which paid $60 million for a D.C. office building this spring—half what it cost to develop it. Too bad for the builder. But good news for downtown, because that low price gave Hines the headroom to renovate and entice a new tenant, law firm Davis Polk, to take half the space.
“That’s the way forward,” said Wachter, of the Wharton School. “Get the buildings in the hands of owners who will be incentivized to transform them. If they purchase them at low basis, with a vision, they have all the upside.”
And for residential conversion, the white whale of downtown reinvention? “Values have to come a lot further down before a wholesale conversion starts taking place,” said Barkham of CBRE. “And in some cases, values might have to go negative.” It would have been hard to imagine, ten years ago, getting paid to take possession of a downtown skyscraper. But it could happen if rental income falls far short of operating expenses. If it doesn’t trigger a regional banking meltdown or a city budget doom spiral, it might, in the long run, help downtown get back on its feet.
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