2023 Q2 Databook
September 29, 2023
Jamie Woodwell; Reggie Booker
Commercial real estate is a large and heterogeneous market. Of the $4.6 trillion of commercial mortgage debt outstanding, roughly $2 trillion is backed by multifamily properties, $750 billion by office loans, $420 billion by retail, $360 billion by industrial and $300 billion by hotel, with the remainder in health care, self-storage, mixed use, and a host of other income-producing properties.
Even within property types, there is remarkable diversity – across property subtypes, markets, property age, deal age, size and more. Looking just at deal size, more than one-third of the multifamily loans that were made last year were for less than $1 million. Almost one-quarter were for less than $500,000. These small loans are largely the domain of the banks. The average size of a multifamily loan made for a bank portfolio was $3.9 million in 2022, compared to averages of $38 million for life companies and CMBS, $19 million for FHA and $18 million for Fannie Mae or Freddie Mac. The bank lending accounted for 77 percent of the loans (51,931 of the total 67,191) but just 42 percent of the dollar volume ($201 billion out of $480 billion).
In today’s market, each commercial property and mortgage sits in a unique place, driven by how it is being affected by changes in the space markets, equity markets and debt markets – all of which are going through adjustments.
PROPERTY FUNDAMENTALS
In terms of supply of and demand for commercial real estate – and therefore changes in rents, vacancies and net operating incomes – different properties, property types and markets are experiencing very different conditions.
OfficeOffice properties are clearly getting the closest scrutiny at present, driven by the changes in office work schedules and questions about how companies will translate work-from-home, hybrid and return-to-office into demand for space.
According to CBRE, “the overall U.S. office vacancy rate hit a 30-year-high of 18.2% in Q2,” with JLL noting 12.5 million square feet of negative net absorption in the second quarter – and effective rental rates decreasing 6.3 percent overall since Q4 2019 (while increasing 11.6 percent for trophy properties.) That said, CBRE found that two-thirds of office buildings were more than 90 percent leased as of Q2 2023 – with smaller buildings and smaller markets more likely to be “full.”
As was the case with retail over the last two years, market participants are working through which office properties may face greater and lesser challenges.
Retail
Two years ago, retail properties were in the crosshairs and broadly viewed as among the most challenged commercial property types. In the years since, investors, lenders and others have come to identify the properties and subtypes about which they feel more and less comfortable. According to Moody’s Analytics, vacancies are trending down (from 10.4 percent at the beginning of 2022 to 10.2 percent in the second quarter) and average asking rents up (by 0.7 percent over the last year). JLL Q2 data shows vacancy rates of 9 percent for malls, 6 percent for neighborhood centers, 4.7 percent for strip centers and 4.2 percent for power centers.
Industrial
Industrial property performance has been remarkably strong of late – with high demand driving vacancies lower and rents higher. That began to turn at the start of the year as demand fell (slightly) and new supply continued strong. Prologis, a bellwether of warehouse space, saw occupancy tick down from 97.7 percent at the end of Q2 2022 to 97.2 percent at the end of Q2 2023. Given the rapid rise in rents in recent years, however, the net effective net operating incomes of their properties increased 8.9 percent from a year earlier as expiring leases rolled to the (much) higher current levels.
Multifamily
Like the industrial market, the multifamily market has been defined in recent years by a significant mismatch between supply and demand of space, which led to record low vacancy rates and rapid increases in rents. Developers responded, pushing permits, starts and completions higher and leading to nearly one million multifamily units currently in the development pipeline.
The result has been an uptick in vacancy rates and moderation in rent growth. Many measures of asking rents now show either flat or declining rents over the last year (after rapid escalations in previous years), with the greatest declines coming in markets that attracted the most new development activity. Among other things, the rise in interest rates has led to signs of a pullback in future new development.
PROPERTY SALES & VALUES
Commercial property sales have plummeted this year. Sales transactions in July were 74 percent lower than a year earlier and sales year-to-date are down 59 percent. The declines aren’t limited to just one or two property types. Sales of retail properties are down 48 percent year-to-date, industrial properties are down 51 percent, office down 64 percent and apartments down 67 percent.
The lack of transactions has meant that measures of property values are likely not as informative as they usually are. Different indexes are telling very different stories – with MSCI showing prices down 10 percent from last year’s peak and Green Street Advisors showing a 15 percent decline. Even within individual series, the results are a bit confounding, with the Real Capital Analytics CPPI series showing office property values down 8 percent and apartment values down 12 percent from last year’s highs. Other signs would appear to point to office being much more negatively affected by current conditions than multifamily.
The same challenges face estimates of capitalization (cap) rates – a measure of the investment “yield” that looks at a property’s net operating income as a percent of the property price. Many series tracking cap rates have barely budged from their recent record lows – for example rising 20 basis points for retail, 30 basis points for apartments, 40 basis points for industrial and 50 basis points for office – all in the face of risk-free yields that have climbed 350 basis points over the last three years.
The takeaway is that measures of property values are likely lagging what is actually happening in the market and the real picture will emerge as more transactions take place (and are recorded).
It’s important to note that whatever does happen to property values, they are coming from a place of remarkable growth in previous years. Depending when a property was last purchased and/or financed, it has likely seen considerable appreciation. Ten-years prior to their July 2022 peak, apartment property values were at just 37 percent of that July 2022 level, industrial prices were at 38 percent, office at 53 percent and retail at 61 percent. The two-year period from 2020 to 2022 saw some of the most dramatic increases, with July 2020 values at 81 percent of what they would be two years later.
Depending on the property and when it was last purchased or financed, considerable equity had been built-up in many parts of the market. The longer the hold period, likely the more that equity grew and the more of a buffer there is to protect against any price declines.
MORTGAGE ORIGINATIONS
Commercial real estate borrowing and lending remained subdued in the second quarter of 2023. Origination volumes picked up from the first quarter but were less than half the level of a very strong quarter a year earlier. Higher interest rates, uncertainty about property values, and questions about some property fundamentals are all contributing to the slowdown. We expect the logjam to begin to break in coming quarters, but the path forward will depend on where interest rates and other aspects of the economy go from here.
Decreases in originations for all major property types led to the overall drop in commercial lending volumes when compared to the second quarter of 2022. There was a 74 percent year-over-year decrease in the dollar volume of loans for health care properties, a 66 percent decrease for office properties, a 55 percent decrease for retail properties, a 55 percent decrease for industrial properties, a 48 percent decrease for multifamily loans, and a 32 percent decrease for hotel properties.
Among capital sources, the dollar volume of loans originated for depositories decreased by 69 percent year-over-year. There was a 60 percent decrease for investor-driven lenders, a 49 percent decrease in life insurance company loans, a 23 percent decrease for commercial mortgage-backed securities (CMBS), and a 11 percent decrease in the dollar volume of government sponsored enterprises (GSEs – Fannie Mae and Freddie Mac) loans.
MORTGAGE DEBT OUTSTANDING
Despite the slowdown in new loan originations, commercial mortgage debt outstanding rose again in the second quarter, driven by increases in the mortgage holdings of life companies, the GSEs, banks, and other depositories. The lack of new loan demand means that fewer loans are being paid off, which in turn is helping to maintain, and in some cases even grow, the amount of credit outstanding.
Total commercial/multifamily mortgage debt outstanding rose to $4.60 trillion at the end of the second quarter, an increase of $37.7 billion (0.8 percent) in the second quarter of 2023. Multifamily mortgage debt alone increased $26.4 billion (1.3 percent) to $2.03 trillion from the first quarter of 2023.
Commercial banks continue to hold the largest share (38 percent) of commercial/multifamily mortgages at $1.8 trillion. Agency and GSE portfolios and MBS are the second-largest holders of commercial/multifamily mortgages (21 percent) at $971 billion. Life insurance companies hold $692 billion (15 percent), and CMBS, CDO and other ABS issues hold $593 billion (13 percent).
Looking solely at multifamily mortgages in the second quarter of 2023, agency and
GSE portfolios and MBS hold the largest share of total multifamily debt outstanding at $971 billion (48 percent), followed by banks and thrifts with $600 billion (30 percent), life insurance companies with $219 billion (11 percent), state and local government with $114 billion (6 percent), and CMBS, CDO and other ABS issues holding $65 billion (3 percent).
LOAN PERFORMANCE
Commercial and multifamily mortgage delinquency rates rose for the third straight quarter but with significant differences by property type. Delinquency rates remain highest for lodging and retail loans, which have improved markedly but remain elevated as a result of pandemic-related impacts. Not unexpectedly, delinquencies among mortgages backed by office loans drove the overall increase this quarter – with the office delinquency rate rising 130 basis points from 2.7 percent to 4.0 percent. By comparison, retail delinquency rates rose 30 basis points, multifamily loan delinquency rates were unchanged, and industrial and lodging delinquency rates declined.
The balance of commercial and multifamily mortgages that are not current increased in June 2023 (compared to March 2023).
- 97.7% of outstanding loan balances were current or less than 30 days late at the end of the second quarter, down from 97.8% at the end of the first quarter of 2023.
- 1.7% were 90+ days delinquent or in REO, down from 1.8% the previous quarter.
- 0.2% were 60-90 days delinquent, unchanged from the previous quarter.
- 0.4% were 30-60 days delinquent, up from 0.3%.
- Loans backed by office properties drove the increase.
- 5.3% of the balance of lodging loans were 30 days or more delinquent, down from 5.6% at the end of last quarter.
- 4.9% of the balance of retail loan balances were delinquent, up from 4.6%.
- 4.0% of the balance of office property loans were delinquent, up from 2.7%.
- 0.8% of the balance of industrial property loans were delinquent, down from 0.9%.
- 0.7% of multifamily balances were delinquent, unchanged from the previous quarter.
Delinquency rates on loans backed by commercial real estate properties rose during the second quarter for most capital sources. Although the uptick in delinquency rates was expected, they remain at the lower end of historical ranges. Higher and volatile interest rates, uncertainty about property values, and stresses in some property markets have increased pressure on some loans and properties.
Not all commercial mortgage loans are facing the same pressures. Loans backed by properties, and property types, with stable cash flows are experiencing different prospects than those that may have seen declines in incomes. Additionally, long-term loans are experiencing less of a change in interest rates than those with shorter terms or adjustable rates. We expect these differences to continue to play out in coming quarters.
Based on the unpaid principal balance (UPB) of loans, delinquency rates for each group at the end of the second quarter of 2023 were as follows:
- Banks and thrifts (90 or more days delinquent or in non-accrual): 0.66 percent, an increase of 0.09 percentage points from the first quarter of 2023;
- Life company portfolios (60 or more days delinquent): 0.14 percent, a decrease of 0.07 percentage points from the first quarter of 2023;
- Fannie Mae (60 or more days delinquent): 0.37 percent, an increase of 0.02 percentage points from the first quarter of 2023;
- Freddie Mac (60 or more days delinquent): 0.21 percent, an increase of 0.08 percentage points from the first quarter of 2023; and
- CMBS (30 or more days delinquent or in REO): 3.82 percent, an increase of 0.82 percentage points from the first quarter of 2023.