Maybe banks, instead of keeping the riskiest CRE loans, securitized them and sold the CMBS? Would be a hoot to find out over the next few years as this plays out.
By Wolf Richter for WOLF STREET.
So another big office landlord – another Commercial Real Estate fund by Canadian CRE giant Brookfield Corp – defaulted on another big floating-rate mortgage for a portfolio of office buildings.
And once again, it’s the holders of CMBS that are getting to deal with this mess, and not banks, maybe because the riskiest CRE loans with floating rates were securitized into CMBS, and banks hung on to the less risky CRE loans? We’ll find out over the next few years as this office-debt-unwind plays out.
Brookfield Corp. funds defaulted on a $161.4 million floating-rate mortgage for a group of office buildings, mostly in the Washington, DC, area.
The mortgage, which had been securitized into CMBS, was transferred to a special servicer, representing the holders of the CMBS. The servicer is working with “the borrower to execute a pre-negotiation agreement and to determine the path forward,” according to a filing on the CMBS, reported by Bloomberg.
Floating rate mortgages on CRE, particularly offices that are being vacated by one tenant after another, have turned into a deadly combination when short-term interest rates surged from near 0% a year ago, to nearly 5% this year.
On the Brookfield mortgage, monthly payments nearly tripled from just over $300,000 before the Fed’s rate hikes last year, to about $880,000 in April, according to the special servicer report.
And occupancy rates at the dozen office buildings in the portfolio dropped to 52% on average in 2022 – meaning nearly half of the space had no tenants and wasn’t generating any rent while mortgage payments were in the process of tripling – down from 79% in 2018, when the mortgage was issued, according to the special servicer report.
By comparison, the overall occupancy rate in Washington DC was 78% in Q1, and in Northern Virginia, the occupancy rate was 75%, both historic lows, according to Savills.
Special servicing rates of CMBS of office mortgages have soared. Among post-Financial Crisis-vintage CMBS, the special servicing rate shot up from 3.1% a year ago to 4.8% in March, according to Trepp, which tracks CMBS.
But that’s just the latest wrinkle for CMBS. The special servicing rates in March were much worse for retail (11.6%) and lodging (6.3%).
This default by a Brookfield fund follows the two defaults by Brookfield DTLA on mortgages and loans on two office towers in Downtown Los Angeles: The trophy tower at 555 West 5th Street defaulted on a $350 million mortgage, which had been securitized into CMBS, and two mezzanine loans, all of it totaling $465 million; and the tower at 777 South Figueroa Street, which defaulted on a mortgage and a mezzanine loan of $319 million.
The big office defaults that have been percolating around the US have largely hit CMBS holders and non-bank lenders. Lenders have recently taken huge losses when office towers were sold at foreclosure — and those lenders were largely CMBS holders.
It’s the riskiest loans with floating rates on buildings with occupancy issues that get weeded out first, such as older office towers. And that’s the wave of defaults we’re now seeing.
Of the overall CRE debt, only about 45% is held by banks, and the remaining 55% is held by investors, such as life insurers and pension funds, and non-bank lenders such as mortgage companies, mortgage REITs, or PE firms, or has been securitized into CMBS, CDOs, and CLOs, which are spread around global bond investors. About 21% of CRE has been securitized into government-backed Agency or GSE multifamily MBS (I discussed the banks’ share of CRE debt in detail here).
Free-money feeding frenzy among investors?
It would be a hoot to find out over the next few years that the chase for yield during the free-money era created such a feeding frenzy among investors of all kinds that they aggressively outcompeted banks by offering better terms on CRE loans.
And so they eagerly originated floating-rate mortgages on overvalued buildings because they figured that the Fed would hike rates soon, and that they would benefit from those rising short-term rates which would push up the floating rates and thereby push up the yield and income from the loan, and therefore protect the value of the loan.
And that makes sense, if they were counting on the Fed to hike by 200 basis points at the total max and then promptly pivot as it had done last time. And maybe they didn’t take the shift to work-from-home seriously, and maybe they expected office buildings to always remain at the center of the US economy, ensconced in an aura of a permanent office shortage. And so maybe they didn’t figure that rates would rise by 475 basis points, while office occupancy rates would plunge, turning into a toxic mix for borrowers, so that they would just default on the floating-rate loans to renegotiate the loans or walk from the properties?
And maybe banks were onto it, and instead of hanging on to those riskiest loans, they securitized them and sold the CMBS to investors? That would be a hoot to find out.
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Seems like a good time to invest in ‘Special Servicing’ firms and companies, no? It seems like they will be plenty busy the next few years.
Then again, the leading players in this area are probably Goldman, JP, and the rest of the usual suspects that know how this game is played from every angle.
Is ‘Special Servicing’ related to the worlds oldest profession?
Nope. Get your mind out of the gutter, LOL. The “special servicer” is an entity that the loan gets assigned to when it gets in trouble; the special servicer — such as a big bank, Wells Fargo may be #1 –represents the CMBS holders. This is spelled out in the loan agreement. The loan stays with the special servicers until either the issue gets cured or the property gets sold, such as in a foreclosure sale, at which point the proceeds from the sale, minus fees and expenses, get transmitted to the CMBS. The loss ratios for CMBS holders on office towers have been in the 75% to 100% range (the One AT&T Center in St. Louis was a 100%-er):
Landlord have mercy!
Most of these loans are non-recourse. In that case, the landlord takes a 100% loss of the equity (often a big chunk of money) and walks away. The rest of the loss is in the debt, and CMBS holders eat that plus fees and expenses.
I’m long on defaults, bankruptcies, layoffs, and financial crises!
Is there an ETF for that?
Mostly CDS. Some are making a fortune as we speak.
Actually default and bankruptcies where irresponsible gamblers and management loses everything will be very good for US.
It’s the bailouts and Fed interventions that keep making everything worse. If Fed doesn’t Pivot, I can wait with cash (tbills) and go long on America.
But if Fed Pivot and starts “Not QE” again to prevent bankruptcies and defaults, it’s best to fall back to gold. In this millenium (last 23 years), thanks to fed actions, gold has beaten dollar denominated assets like nasdaq, treasuries, San francisco real estate, us real estate etc.
Gold is not even an investment. It’s just a store of value and an insurance against inflation. That tells me that US has not a good place to invest in this millenium.
My guess is that the banks were more likely to get a guarantee. The CBMS folks were more likely to get 20bps more in rate.
When marketing the CMBS, the rate is discussed, the guarantee — probably not as large of an item as the yield.
My thought is that the smaller banks always get a guarantee, though interestingly I spoke with someone with loans in the 5M to 20M range and he was borrowing at East West Bank with no personal guarantee for some premium to the guaranteed rate, but … well …
If you own banks today, you probably want them to have customers committed to paying their bills. Especially if you loaned on an office tower. Someone needs a MEME drawn up with the towering inferno movie combined with the bank or CMBS who has the most loans to office towers.
Those towers have a long way down to go.
It does make you wonder what kind of professional intermediary would put his clients into the lower tranches of CMBS for an extra 20 bps…decade long yield starvation or not.
And regarding the bank originators who sell off this sort of dross, moral hazard/adverse selection concepts are usually taught in Econ 201 level courses…how do professional buyside intermediaries keep putting their clients into jackpots (and how do they still have clients? Who embraces the HMW vampire squid…twice?)
Er, HNW, not HMV.
Lots of bank CRE loans are owner occupied which reduces the risk I guess.
Jeez, talk about a stunningly poor investment: if the interest rate goes down, your yield will decline and the fund gets to pocket the extra cash from its rents. And if interest rates go up, sure your nominal yield goes up but at some point, the borrower will execute a ruthless default and leave you hanging precisely when property values are down (i.e. when interest rates are up).
IOW, you’re buying a bond in which your *best* case scenario is slowly bleeding yield because a rise in interest rates will prompt a default from these covenant-lite non-recourse loans that are just begging to be taken advantage of…
That’s where the interest rate cap works.
Anddd the S&P is up again… wild world we live in
Funny what you make a big deal out of. Dow and Nasdaq were down a smidge and the S&P was “up” 3.6 points or 0.09% 🤣
If you look at every bear market going back decades, this happens at exactly this time. Stocks rise above the downtrend from the peak, bulls pile in, indexes then fall using the falling trend line as support, then they slice through and it’s the real pain.
Classic bear trap, as I understand the recent writings of Lance Roberts and a few others.
Bitcoin over 30k 🥳
Of course the USD alternatives go up when the only “fix” for baked-in, continent wide ZIRP-aftermath defaults is…more, endless dollar printing.
Yup bitcoin will see 100k if Jerome remains in office LOL
Bitcoin was over 30k a week ago 😎
LOL. Bear market rallies are not new. I know that the 2000 bear had multiple 20% rallies but I just don’t remember the feel of them (short emotional memory). The current rally off the bottom on the S&P is not even 20% yet but it sure feels weird.
Man – it seems we will have dominos falling over the next couple years. As an investor, you are told you are in 1st position (with debt / bonds) and equity holders are the only ones who can get wiped out. You never consider the collateral is overvalued by 50% or even more in some cases. It’s like you are investing a dollar to get 30-50 cents back. So much for safe 1st position lending investing !!
“you are told you are in 1st position”
You are right about huge collateral overvaluation…but it gets worse.
Modern era “finance” tends to layer multiple tranches of debt on that already inflated collateral…so some people who think they hold safe, secured bonds…are actually first in line for 100% losses even if the collateral recoups a mighty 80 cents on the dollar…and as Wolf has pointed out, some “collateral” recoups zero cents.
Bizzarro world gets its start when the G prints “money” far in excess of real assets. That “money” has to go somewhere…and it goes into delusions.
Time to go long on wheelbarrows.
There’s no way Banks would hide bad loans in mortgage-backed securities, that would be inconceivable!
“I don’t think that word means what you think it means.”
– Princess Bride
UK financial center Reichmann bros, 1970’s.
Canadian here, I remember their debt was rated AAA and then a year later default. It was rated like government agencies like Ontario Hydro. That was an ugly time because commercial real estate fell 90%. I guess if you are doing all this through a corporation the worst case is the corp loses and so do the mortgage holders. I always thought the Reichmanns managed to come out with some money.
Just amazing what can be sold and packaged into CMBS and then the kicker about upside for higher rate hedge possibilities. Plus the repricing of assets lower is a slow process . The ATT building discovery price was a surprise to me .
So….how long before the commercia real estate business and the Banks ask the Government to also guarantee their CMBS. That would be a hoot but it would not surprise me. Specially if a bunch of State Pension plans hold the CMBS.
Yes, we’d all explode into riotous laughter around here if this happened. Those RE people never give up fishing for government handouts. So it would be really funny if they succeed again.
Fed bailed out Corp bonds (although minimal than expected) under Special Vehicle purpose fund. If the pension funds cry (just like in UK) you don’t think, Fed will NOT act?
Fed appears authorized to do ‘whatever needed’ in the name of ‘financial stability’ both in USA and World wide.
It does not matter if FED did it minimally, what matters is what they are willing to do ( they can always work around the law/rule ).
So, yes, in the name if financial stability they’d do anything.
A case in point, they saved a lot of rich un insured depositors in SVB. The SVB investors were let yo eat their losses in deposit, there would not have bene any systemic failure but we all know how Fed and treasury worked over the weekend to save these rich people.
If by “funny” we mean “social unrest,” then, yes, a hoot. Don’t forget it was the fallout from 2008 that gave rise to the “Taxed Enough Already” movement, the “Occupy Wallstreet” movement, and the rise of populism in general, on both sides of the supposed aisle.
If the banks get massively bailed out again, while inflation and rising property taxes, etc hit the rest of us hard, something wick-er this way will come.
See also; Europe, circa 1930.
Sorry, Wolk, that was meant for ru82, not ye.
Good god, who hid the coffee?
I kinda like Wolk®
The WOLK STREAK REKORD©
Just give me a shout-out in the movie credits, Wolk!
“Specially if a bunch of State Pension plans hold the CMBS”
Hmm…what do you think they *do* hold…
Well, CMBS and LP interests in a couple hundred SVB depositors and a buttload of Apple at a 35 PE…
And Brookfield mentions just a small percentage of their portfolio in a news announcement I read.
Just reading about First Republic bank and some of their issues one being that a huge portion of their home mortgages they hold and over last 5 years interest only mtgs made up a higher share of originations than any other regional bank. So not only are they on the hook for 3 percent loans for 30 years no principle payments over that same period of time . I doubt those homes will be sold anytime soon. The interest only loans that I had seen in early 80s were a result of higher rates not low rates and usually capped at 5 years for the interest only.
There will be vultures waiting on the sidelines to pick the carcasses and wait for a while to repackage them to investors at high prices again. Circle of life thing.
A lot of these older office buildings will be worth just the land they sit on and will be torn down once they’re sold in a foreclosure sale, and the site will be redeveloped into residential.
Some of these older office tower properties might have a negative market value if demolition and environmental compliance costs of getting rid of the obsolete tower exceed the market value of the land on which it sits. In that instance the obsolete building slowly rots and blights the streetscape. This happened all over the Rust Belt and was caused by offshoring of domestic industries. one way free trade and population loss. Will WFH and perceived urban disorder cause a similar destructive secular trend? Population and business loss are the big red flags, and if the era of free money is really over due to inflation, some US cities will be in trouble.
I was driving past one of the long term empty office buildings (5+ years) last week and noticed that the huge “For Lease” sign was gone. Had they finally gotten a tenant after all these years?
Nope. Later I drove past going the opposite direction and saw that sign had just fallen over, swallowed by the weeds.
This is the building where, a few months ago, several of the neglected trees blew over, took out about four utility poles, and closed the entire six lane street for a day and a half. I’m pretty sure that added to their expenses.
Businesses should try allowing all workers to bring their dogs to the office.
Then the dog lovers would show up at the office, and the cat lovers and those that like neither would REFUSE to come to the office, not even for three hours? Is that what you want?
I got my alpaca in the car and ready to go! She loves when they serve Danish rolls at the early morning meetings but coffee gives her horrible gas.
I snorted coffee through my nose at the thought of a “Bring your alpaca to work” day. Thank you for the laugh!
“That’s $25,000 alpaca, you blot that $h!t, you don’t rub it…”
I couldn’t resist.
I dunno, Wolf… I would go back to the office in this instance with dog, and the cat would be happy to have some peace and quiet without dog at home. Sounds like the answer to all our woes. Then we’ll also all buy doge coin and get rich again.
“That would be a hoot to find out.” Yep, until you discover your pension fund or insurance company is holding some of these dogs.
Who’s holding these CMBS’s? If it’s pensions, 401k’s, or retail, sounds like the start of 2008 just with different vehicles.
I hope so.
It’s not 2008 because CMBS are just way too small. The outstanding pile is less than 1/10th the size of residential MBS.
Sorry…..I just have to share this….especially after my coffee with anisette.
The congressional house plan to address our government overspending is
hold budgets to a 1% increase each year.
They don’t mention that the 2019 budget was 4.4 billion and the next proposed one will be 6.8 billion. Gee….thats what I call a two handed whopper. All with a straight face. Don’t play poker with these people.
These guys are as funny as Powell.
If we raise rates the government debt is going to explode with interest at a trillion plus per year….. who is going to buy those bonds…..yep…..Powell, nobody else will. That ought to goose inflation big time.
If we cut rates inflation goes into overdrive. The dollar collapse and commodities explode.
Pick your poison…..and thank the whole crew……Powell, Congress and the executive branch…..all going back 60 years…..and lets not forget Bernanke, Yellen and Greenspan.
What a group of goofs.
Housing stocks are all breaking out to the upside……do they know the pivot is coming. Sure don’t sound like higher rates.
It amazes me how loose the lending terms got. Floating rate, Non Recourse, No Guarantee. It will be interesting to see which investors get hosed by these loans gone bad. Hope not too many pension funds guaranteed by the Pension Guarantee Corp.
High rise office re-use:
“On the southern outskirts of Ezhou, a city in central China’s Hubei province, a giant apartment-style building overlooks the main road. But it is not for office workers or families. At 26 stories it is by far the biggest single-building pig farm in the world, with a capacity to slaughter 1.2 million pigs a year.” -Guardian
CRE is about to enter a world of hurt, since this is just the beginning of what lies ahead. Most of the regionals that I work with have significantly tightened lending standards by decreasing LTVs while increasing DSCRs. Meanwhile, higher cap rates are lowering property values with a wall of over $800B in small cap and middle market deals coming due in the next 2 years. Borrowers will either be forced to inject capital to refinance or they will be forced to sell and take their lumps and bruises. It is not going to be a pretty picture.
Sure banks may have less exposure, but they still need to originate, and they just offloaded alot of that to investors who will/are getting smacked…
You think investors will circle back now with any other toilet paper from the same banks in the next few years?
banks will get smacked too
Some of the old business buildings could be used to farm edible bird nests, which in Thailand are exported to China for big money.
“Bird’s nest condos … dominate the skyline of the [Pak Phanang] district. The buildings were constructed to encourage nest building by edible-nest swiftlets when the price of edible bird’s nests boomed following the 1997 Asian financial crisis.
Each of the approximately five hundred 10 to 15 story buildings can generate income of around $1.5 million per year ($750 million total). As of 2018 the export price of farmed nests was around $2,400 per kilo. Exported to China, the price doubles, selling for up to $4,800 per kilo.
Although, sadly, this would be a drop in the bucket of the United States 400 billion or so trade deficit with China.
What’s bothering me is the giant office construction wave going on in Manhattan with many more supertalls everywhere. While at the same time office workers stay home on friday and monday.
Something’s gotta give.
“Something’s gotta give.”
The older office towers.
As soon as these sorts of accounting shenanigans can no longer be obfuscated, something will give. No worries there.
Or convert them into “hog high rises” like in China. It shouldnt cost much to retrofit since Wall Street hogs and Chinese hogs are similar.