A High-Risk Environment – June 10, 2024

At its regularly scheduled June 11-12 meeting, the Federal Reserve’s Federal Open Market Committee is widely expected to maintain its policy rate in the current range of 5.25% to 5.50%, notwithstanding rate reductions earlier this month by the Bank of Canada and the European Community Bank. A hotter-than-expected June hiring report undoubtedly weighs strongly in favor of maintaining the status quo. 

So when can the markets expect to see the federal funds rate start moving downward? At the FOMC’s July meeting? If not then, how about in September? 

Analysts at S&P Global aren’t holding their breath for a rate cut at either of these meetings. In a new report on the 2024 outlook for commercial real estate debtholders, the analysts pushed the onset of rate reductions back to December, “several months later than we previously forecast.” 

This delay in rate cuts until at least the fourth quarter is “unwelcome news,” analysts wrote. “CRE borrowers that postponed refinancing with hopes for a rate cut in mid-2024 could get squeezed. As such, refinancing risk for debt maturities in the next two years remains high, particularly for struggling property types and properties that are unable to increase cash flows.” 

S&P Global’s report is titled “CRE Debtholders Are Confronting Increasing Refinancing Risk and Charge-Offs In 2024; Outcomes Will Vary.” One reason for this predicted disparity in outcomes is that the level of risk varies by lender groups across the $3.7-trillion spectrum of CRE debt. 

Banks remain the primary capital source, accounting for about half the total. Within the banking space, approximately 60% of loans came from institutions with less than $50 billion in assets. Accordingly, the report stated, “banks with CRE concentration could face greater risk of losing the confidence of depositors and counterparties.” 

That loss of confidence may extend to rating agencies as well. CNBC reported that Moody’s had placed the ratings of six U.S. regional banks on review for downgrade due to their substantial exposure to commercial real estate loans. 

Much of their CRE lending activity occurred in the low-interest-rate environment that prevailed prior to the FOMC’s cycle of rate hikes. More recently, according to S&P Global, banks have tightened their lending standards on commercial properties.  

“The last Senior Loan Office Opinion Survey on Bank Lending Practices points to fewer banks further tightening lending standards, but lenders remain selective and they are only granting loan extensions or modifications if it makes economic sense,” the S&P Global report stated.  

“Though modest so far, we believe a rising number of CRE loans have been modified in some way, most notably through term extensions for banks. We also believe upcoming maturities are leading to a buildup in criticized loans as banks further assess their portfolios’ creditworthiness.” 

The percentages of criticized loans (performing loans that are showing early signs of higher risk), and their concentrations in major markets, vary by property type. Trepp reported last week that San Francisco continues to see the highest percentage of criticized loans in office, although Washington, DC’s criticized loan share has surged in the office sector. Less pressured than office is multifamily, where the Atlanta MSA now leads in criticized loan share. 

A smaller but nonetheless significant share of CRE loans comes from insurance companies, and S&P Global sees fewer signs of trouble here than it does in the banking world. “Life insurers’ conservative underwriting has historically helped to keep delinquencies and foreclosures low, and thus far the commercial mortgages performance has been holding up well, especially compared with the broader CRE market,” according to S&P Global. 

Then there’s CMBS, which has seen an increase in issuance compared to the year-ago period. “For CMBS, we expect the refinancing picture to remain murky in the near term, especially within certain segments of office, retail and multifamily,” the report stated. “Deals approaching their maturity dates that have been unable to refinance given current market conditions have already led to sizable increases in the delinquency and special servicing rates.” 

Summing up the CMBS outlook, S&P Global’s analysts wrote, “We will continue monitoring how issuance reacts in the second half of 2024, as expectations have shifted to a much slower pace of benchmark rates reductions.”