Commercial Real Estate Bond Distress Reaches Record High

The commercial real estate sector, particularly the apartment market, is experiencing significant distress due to the Federal Reserve's recent rate cuts not providing the expected relief. The distress rate for CRE-CLO bonds, which are packaged commercial real estate mortgages, reached an all-time high of 13.1% in Q3. This indicates that one in seven loans is currently distressed, with the apartment sector being the most affected, showing a distress rate of 13.7% in September. The Wall Street Journal reported that there are $14 billion in currently distressed apartment bridge loans and an additional $81 billion in potentially distressed loans. This means that 95% of all apartment bridge loans are either currently distressed or in imminent danger of distress. The apartment market's distress is attributed to the reckless lending practices during the 2020-22 period when interest rates were near zero, and lenders underwrote property acquisitions with a 1.0x debt service coverage ratio, meaning the initial net operating income of the property was projected to just cover interest payments, with nothing left over. The interest rates on these loans have increased significantly since mid-2022, leading to higher interest payments for properties. For example, a property with a net operating income of $1 million would have had interest payments of $1 million at the then-prevailing interest rate of 3.5%. With the current SOFR at 4.9%, the total interest rate is now 8.4%, leading to interest payments of $2.4 million, while net operating income has not increased significantly due to stagnating real wages and increased expenses like insurance and property taxes. Lenders are relying on the Federal Reserve to provide salvation through loose monetary policy, such as purchasing treasuries to drive yields lower. However, market signals indicate that a regime that cannot stop spending and continues to appropriate the property of its citizens through inflation will provide upward pressure on Treasury yields, forcing the commercial real estate market to work out its own salvation in a free market context.