S&P Global Ratings' webinar "CRE Credit Outlook: CMBS, REITs, and Banks Update" on Feb. 14, 2024, made clear that CRE in the U.S. is not out of the woods yet. A replay is available here.

Slowing economic growth and the cooling labor market will likely weaken demand for CRE, reduce occupancy rates, and cap rent increases, Ana Lai, CFA and Managing Director for U.S. REITs, warned. Price discovery was pushed to the back burner in 2023, with transaction activity remaining well below pre-pandemic levels. Already strained asset valuations will suffer from upcoming refinancing needs that will cause forced asset sales at discount prices, lead to an increase in distressed sales, and widen cap rates.

Slightly Higher Issuance In CMBS But Headwinds Abound

Private-label CMBS issuance will climb to $50 billion this year, from $39 billion in 2023. Banks' retreat from lending could spell opportunity for CMBS and increase their market share. Conduits should keep pace with single borrower deals, especially with the newer five-year product seemingly gaining acceptance.

One key consideration in the medium term for CMBS is a potential rise in event risk. It remains to be seen if lower-leveraged loans can outweigh the risks associated with increasingly concentrated CMBS pools. The large number of refinancings, versus acquisitions, and lackluster transaction volumes could pose additional questions, especially in light of high interest rates and low asset values.

The credit picture is challenging, with CMBS delinquencies climbing by 173 basis points (bps) year-on-year to 4.3% in January 2024. At just over 6%, the office sector experienced the highest late payment rate, ahead of retail, lodging, multifamily, and industrial delinquencies.

Unsurprisingly, the ratings outlook on CMBS took a turn for the worse over the past 12 months (see chart 1), with the spike in downgrades in November 2023 resulting from the revision of our capitalization rate assumptions for class B office assets. "Overall, we expect downgrades will continue in 2024, as will the increase in delinquency and special servicing rates," James Manzi, CFA and Managing Director for Structured Finance Research, said.

Chart 1

Offices Put A Drag On REITs

REIT downgrades far outpaced upgrades in 2023, a trend that continued into early 2024 (see chart 2). Credit quality will weaken modestly in 2024, with 26% of ratings either with negative outlooks or on CreditWatch negative as of Feb. 6, 2024. In contrast, ratings with positive indicators only accounted for 4%.

"The negative rating bias largely results from our continued negative view on office REITs," Michael Souers, Director for U.S. REITs, said. "40% of our ratings on U.S. office REITs are now speculative-grade, compared with about 20% of ratings in the North American REIT universe."

Office REITS could suffer from muted job growth, low tenant retention rates--which are still 10% below pre-pandemic levels--and high vacancy rates. The valuations of office assets, which declined sharply over the past two years, could remain stressed until the Fed starts to cut rates in the second half of 2024.

On the plus side, office utilization increased modestly in recent weeks, capital market conditions improved, and lease expirations are generally manageable. "We expect occupancy rates for our rated office REITs will weaken modestly in 2024, with some looking at a 2% to 3% contraction from year-end 2023," Mr. Souers said.

Chart 2

CRE Fincos Center On Liquidity

Downward rating pressure remains. In 2023, we downgraded two of the six companies we rate and revised our rating outlook on one company to negative. Currently, the rating outlook on four of the six CRE fincos we rate is stable, one is negative, and one positive. Similar to other CRE sectors, CRE fincos are not immune to high interest rates, which increase cap rates and reduce property valuations. Unsurprisingly, office real estate remains under intense pressure as the more permanent adoption of hybrid work is slowing the recovery from low office utilization (see chart 3).

"While rated CRE fincos' office loan exposure has declined since 2020 as lenders focused on originating loans for other property types, the existing office loan book continues to remain under pressure," Gaurav Parikh, CFA and Director for Non-Bank Financial Institutions, said.

A further deterioration in office loan portfolios remains likely, especially for companies that are exposed to dense markets, such as New York and San Francisco. CRE fincos, which are typically well versed in dealing with troubled properties, will also have to decide how to handle stressed or defaulted loans--be it by maturity extensions, partial loan paydowns, or foreclosures.

CRE fincos primarily depend on secured repurchase facilities to fund their portfolio. This, together with a deterioration in asset quality, could result in margin calls on these facilities. In the current market, they prioritize liquidity over new loan originations, with some companies also having reduced their quarterly dividends because of the expected decline in property valuations and the potential for margin calls. While some facilities allow for collateral to be marked based on market interest rates and credit spreads, many other facilities only allow for marks based on credit valuation adjustment events.

Chart 3

Size Matters For Banks' CRE Exposures

Banks remain the largest source of funding for CRE and accounted for about 50% of the total CRE debt outstanding in the third quarter of 2023 (see chart 4). About 60% of these loans are in the hands of banks with less than $50 billion in assets.

"The size of the bank matters," Stuart Plesser, Managing Director for U.S. Banks, said. "In the case of banks with over $100 billion in assets, CRE loans only account for 12.5% of the total loan book but represent roughly 38% for banks with less than $10 billion in assets." Some of these smaller banks, which are typically not rated, could feel the repercussions of their high CRE exposures over the medium term.

Even so, CRE delinquency rates remain low, compared with those in the CMBS market. Part of the reason is building owners' ability to stay current on loans until leases come due. More importantly, the CRE sector is diversified enough to cope with the poor performance of some property types, including offices.

Mr. Plesser warned against tarring all CRE loans with the same brush. "Each property may behave differently from a cash flow standpoint, so making sweeping comments on banks' CRE portfolios can be misleading." A thorough case-by-case evaluation is still the way to go.

Chart 4

Appendix

Our bank CRE stress test indicates how well banks can handle further CRE stress

To evaluate the possible effect of CRE losses on the capital position of the banks we rate, we performed a stress test. According to our stress test, rated banks with a CRE-loans-to-total-loans ratio of more than 30% would experience a 28% decline in tier 1 capital in the case of a 10% loss rate for all CRE loans. The same stress test would result in a 4% decline in tier 1 capital if we only considered office exposure (see chart 5).

While the decline in capital is not significant for the aggregate set of rated banks with high CRE exposure, capital declines would be more significant for banks with the highest CRE exposures within this subset. So far, however, these banks' CRE portfolios are holding up.

Even so, a rise in CRE losses could result in deposit outflows and customer attrition. While most of our outlooks on U.S. bank ratings are currently stable, negative rating actions could ensue for banks with the highest exposure to CRE, particularly if it becomes apparent that more significant CRE losses will materialize.

Chart 5

Related Research

• Replay and slides of the "CRE Credit Outlook: CMBS, REITs and Banks Update" webinar from Feb. 14, 2024
• U.S. CMBS Overall Delinquency Rate Rose 21 Bps To 4.3% In January 2024; Office Saw The Highest Increase, Jan. 31, 2024
• Declining Asset Quality And Funding Obstacles Follow U.S. Finance Companies Into 2024, Jan. 23, 2024
• U.S. Bank Outlook 2024: Facing A Slower Economy, Tighter Regulation, And A Potential Drop In Rates, Jan. 11, 2024
• Industry Credit Outlook 2024: Real Estate, Jan. 9, 2024
• Sixty Ratings From 11 U.S. CMBS Deals Placed On CreditWatch Negative Following Revised Capitalization Rate Assumptions, Oct. 12, 2023
• Uneven Global Office Recovery Is Squeezing Credit Quality, Oct. 3, 2023
• Guidance On Global CMBS Property Evaluation Methodology Updated, Sept. 27, 2023
• Credit FAQ: What Declining Commercial Real Estate Values Could Mean For U.S. Banks, June 5, 2023
• Stressful Conditions For U.S. Commercial Real Estate Are Raising Refinancing Risks, June 5, 2023