U.S. and European commercial real estate (CRE) markets continue to endure historic stress due to higher interest rates and secular headwinds. The market values of office and retail properties, in particular, have declined considerably over the past several years, and credit risk among our rated commercial mortgage-backed securities (CMBS) has risen in conjunction with the pressure in CRE markets. In this commentary, we present some of the causes underlying this stress and discuss how it has put downward pressure on our CMBS ratings.

U.S. And European Commercial Real Estate Values--Especially Office And Retail--Are Under Pressure

While U.S. and European commercial real estate remains broadly strained due to higher interest rates, office and retail mall valuations have come under acute stress from the added pressure of declining property-level income, attributable to secular headwinds (see chart 1).

Chart 1

The most striking market value declines have been in the class 'B'/'B+' office segment, particularly in the U.S., which has seen an average 59% drop in property values between the beginning of 2020 and the latest reading in 2024, according to Green Street data. For comparison, the same segment experienced only a 42% peak-to-trough market value decline during the GFC, when price pressures were mostly attributable to market contagion, excessive leverage, and liquidity issues, rather than fundamental secular concerns. Meanwhile, class 'A' U.S. offices have undergone comparatively less drastic (but significant) price depreciation on average, with valuations falling 40% from their recent peak in first-quarter 2020, based on Green Street's June 2024 institutional quality CRE indices. It is important to consider that these figures represent average market value declines, and do not provide information about the substantial variation around the mean.

The retail segment is also seeing more severe price decreases than those during the GFC. In the U.S., class 'A' mall values declined 47% on average from fourth-quarter 2016 to second-quarter 2020, and valuations remain at depressed levels despite a brief recovery period in 2021. Enclosed older-vintage retail malls have continued to suffer from tenant turnover and more significant value declines. In Europe, the decline in class 'B'/'B+' retail property values has been slow and steady, with property prices gradually deteriorating by roughly 47% since the end of 2015, partly due to ongoing competition from e-commerce.

What Are the Causes Of The Stress?

We focus on the office and retail segments to look at the causes of this acute stress.

Office

The strain in the office segment began in 2020 with the onset of the pandemic. The combination of higher interest rates, inconsistent corporate visions of ideal work arrangements, and higher vacancy rates significantly complicate the sector's ability to access capital, making the outlook uncertain. Long lease terms initially masked the level of distress, but demand for office space has persistently declined.

Lower asking and effective rents and higher availability rates across most markets can be attributed to the shift toward remote or hybrid work policies. The tendency for parts of the labor force to work remotely has been a major shift--which has so far only partly reversed--in the office segment. This ability and willingness on the part of millions of workers to work remotely has incentivized many companies to downsize their office real estate footprints. In some cases, leases have not been renewed, and finding new tenants can be challenging in the current environment. In the U.S., business districts with longer-than-average commute times have been hit particularly hard.

These pressures are reflected in higher vacancy rates. According to Colliers, U.S. office vacancy rates hit 17.5% in the first quarter of 2024, substantially up from less than 12% before the pandemic in 2020 and surpassing the previous high of 16.3% during the GFC. In March 2024, the number of visits that U.S. workers made to physical office buildings was still down about one-third relative to March 2019, according to the Placer.ai Nationwide Office Building Index.

In the case of the European office segment, office attendance rates have recovered more than in the U.S., but companies have still reduced their real estate footprints. According to Schroders and Real Asset Insight, European office vacancy rates sit at 8.2%, up from 6.5% prior to the pandemic but lower than the 2014 peak of 10.5%. We therefore believe the main driver of the value decline to date for European offices has less to do with vacancies and instead is primarily driven by the change in the prevailing interest rates. In addition to suppressing valuations, higher interest rates have complicated refinancing. As commercial mortgage loans reach maturity, properties need to be refinanced at interest rates that are substantially higher than those on the original loans.

Retail

The strain in the retail segment has been partly attributable to competition from e-commerce for the past decade or more. A substantial number of subpar malls continues to be burdened with maturing loans that borrowers are unable to refinance, leaving servicers few options aside from continuing to offer loan modifications and extensions. In the case of malls, this is because it is typically economically more advantageous to "amend and extend" rather than foreclose, which could lead to immediate and potentially severe realized losses.

CMBS Ratings Have Been Trending Lower Since 2020, Reflecting The Stress

Given the level of stress in underlying real estate markets, the ratings on CMBS have come under pressure over the past several years. We have lowered between 5% and 15% of our outstanding CMBS ratings each year since 2019, and CMBS ratings have fallen by an average of 0.3 notches over the past 12 months (see chart 2).

Chart 2

There are many factors that influence the performance of CMBS tranches, and we carefully consider the credit-related features of each transaction before taking any rating actions. We have lowered 732 of the 2,799 CMBS ratings that were outstanding at the beginning of 2020 (i.e., a 26.2% downgrade rate), including 8% of those that were rated 'AAA'. Of these, 134 tranches have defaulted (i.e., a 4.8% default rate). Over the same period, six tranches initially rated 'AAA' have defaulted (corresponding to a 0.6% default rate), in some cases, suffering a principal loss.

Lack Of Price Discovery Brings Future Uncertainty

Many central banks have started lowering benchmark rates or have signaled that they will do so in the future. The timing is unclear, however, and it's reasonable to expect more CRE loan defaults on the horizon as pre-pandemic borrowings mature and need to be refinanced in a higher interest rate environment. So, while office vacancies appear to be stabilizing (at least in Europe), the real estate environment remains more challenging than it was when these loans were originated. Moreover, we have observed little sales activity in some CRE segments, including office, making price discovery difficult. It is therefore possible that the bottom of this CRE cycle has not yet materialized, and that there is more distress in store, especially for lower-quality office properties in secondary locations. If this is the case, CMBS ratings could come under further pressure.

It is important to understand, however, that the CMBS sector is heterogeneous and that each transaction is unique. For example, in the case of some unhedged floating-rate European CMBS transactions, interest coverage has declined even when properties' net operating income has been stable. In this situation, special servicers may be more likely to speed up disposal of assets and accept lower prices to avoid interest shortfalls. However, in some instances, the special servicer may be economically incentivized to delay the sale of the property. Transaction-specific effects are also pronounced in the U.S. single-asset, single-borrower (SASB) transactions.

We will continue to monitor the office and retail sub-sectors of the CMBS markets in both the U.S. and Europe and provide timely updates as new credit-relevant information is revealed.

Related Research:

• U.S. CMBS Update Q2 2024: Office Under Severe Distress; SASB Issuance Is Still Booming, July 8, 2024
• SF Credit Brief: U.S. CMBS Delinquency Rate Rose 22 Bps To 4.8% In June 2024; Updates Provided On Modification Rate By Property Type, July 1, 2024
• CRE Debtholders Are Confronting Increasing Refinancing Risk And Charge-Offs In 2024; Outcomes Will Vary, June 3, 2024
• Lower Margin For Error On Debt Service Coverage Raises U.S. CMBS Performance Risk, May 21, 2024
• European CMBS Monitor Q1 2024, April 29, 2024
• European CMBS Can Ride The Refinance Wave, April 11, 2024
• U.S. CMBS Update Q1 2024: Office Performance And Interest Rates Are Still Driving The Conversation, April 10, 2024
• European Annual CMBS Monitor 2023, Jan. 31, 2024
• European CMBS Monitor Q4 2023, Jan. 29, 2024
• European CMBS Monitor Q3 2023, Oct. 25, 2023
• U.S. CMBS Update Q3 2023: Office Distress Driving Rating Actions; Conduits Leading Subdued Issuance, Oct. 13, 2023
• European CMBS Monitor Q2 2023, July 21, 2023
• U.S. CMBS Update Q2 2023: The Market Continues to Adjust While Offices Drive Credit Concerns, July 14, 2023
• U.S. SASB CMBS Office Loan Refinancing Risk: Mind The Funding Gap, June 7, 2023
• Scenario Analysis: European Office CMBS Withstands Vacancy Stress, May 23, 2023
• European CMBS Monitor Q1 2023, April 25, 2023
• U.S. CMBS Update Q1 2023: Higher Capitalization Rates And Office Uncertainty Drive Market Angst, April 17, 2023