More owners of US offices are missing payments on their commercial real estate loans, in a sign of the pressures caused by higher interest rates and inflation combined with the effects of remote work on office occupancy, leasing and valuations.

In July, more than 4.95% of US office loans were delinquent in commercial mortgage-backed securities (CMBS), meaning they were late on their payments by at least 30 days, according to Trepp, a real estate analytics firm. This office loan delinquency rate is up from 1.62% a year earlier and is the highest level recorded since May 2018.

Put simply, CMBSs are financial instruments that pool a collection of commercial real estate loans. They are sold by banks in the form of bonds to investors, who then receive repayments of the mortgages that back the security. While office delinquencies were above the overall CMBS delinquency rate (4.41%) in July, they remain below other property types, such as retail (6.86%) and lodging (5.85%), which have been impacted by a change in post-pandemic shopping and travel habits.

Stephen Buschbom, a research director at Trepp, tells fDi that there is a “liquidity squeeze” in commercial real estate markets due to tighter credit conditions, lower assets values and a lack of loan repayments: “This situation is particularly difficult for office and retail properties maturing right now.”  

More than $310bn of CMBS debt is set to mature in the US by the end of 2024, according to Trepp, with a significant number of these loans being originated in 2013 and 2014 when interest rates were lower. Due to a tightening of credit conditions, lenders have become very selective about the type of commercial real estate loans they are willing to quote and originate, according to Mr Buschbom.

More reading on real estate and cities:

• Office demand significantly reduced by pandemic, says McKinsey
• City of London: back to the drawing room
• Real estate markets frozen by tough conditions

In this climate, real estate investors are using any cash on hand to reduce debt levels and protect existing assets, rather than grow their portfolios. Many lenders are also seeking to reduce their exposure to commercial real estate loans on their books.

“We’re in the early innings of a massive deleveraging cycle in commercial real estate,” says Ralph Rosenberg, a partner and global head of real estate at US private equity group KKR. In major “urban cores” and office markets, he expects there to be “massive value destruction” for real estate asset owners and lenders who have financed these assets.

This year’s collapse of regional lenders, like Silicon Valley Bank and Signature Bank have fuelled fears about the availability of financing for commercial real estate. Despite competition from CMBS and life insurance companies, banks accounted for 50.6% of all outstanding commercial real estate debt at the end of 2022, according to Trepp. 

Banks’ internal risk ratings for office loans give an indication of which US metro office markets are at the highest risk of collapse. San Francisco has the highest level of criticised office loans, with 64.1% of loans rated as high risk as of the first quarter of 2023, according to Trepp’s anonymised loan level repository (T-ALLR) data.  

McKinsey forecasts that office demand in San Francisco will be 20% lower in 2030, compared to the pre-pandemic year of 2019. This has been driven by the downsizing of tech firms, an exodus of companies and residents as well as social problems like increased crime, drug use and homelessness. The second most at risk US office metro market is Washington DC, where 47.3% of loans are criticised, followed by New York (38.8%), Baltimore (31.7%) and Phoenix (26.7%), according to Trepp data. The risks to lenders in these markets has played out in the news. In April, Toronto-based Brookfield defaulted on a $161.4m mortgage for 12 office buildings in Washington DC and Los Angeles.

Some cities have taken proactive measures to encourage investors to repurpose older offices, as concerns mount over a flight to higher-quality buildings. In May, New York launched its Manhattan Commercial Revitalisation Program, which provides tax incentives to support investors renovating old office buildings in Manhattan south of 59th Street.

“The only way to encourage that capital investment is to recognise that you’re gonna have to offset or incentivise the investors to take action,” says Mr Buschbom, noting that tax abatements are a good way to do that.