Smaller Balance CRE Loans May Be the Ticket for Investors

For years, big CRE loans seemed to be safer. That may no longer be the case.

Trepp noted in a new report that the commercial mortgage-backed security (CMBS) delinquency rate has been on a big upswing — 51 basis points to 4.41% in July 2023. Office is the biggest problem, though retail is also at issue as valuation drops have become massive.

“The office delinquency rate has risen 338 basis points since December of last year and is the highest it has been since May 2018,” Jack LaForge wrote for Trepp. “Office vacancies are rising as firms adjust to a hybrid work environment, and property financial performance is suffering. It is easy to cast generalizations about the sector, but not every office loan is the same.”

But something else is not the same, at least as it used to be. According to LaForge, CMBS loans below $50 million used to be more in danger of delinquency than loans at or above $50 million. And yet, July showed an inversion of that standard, only the third time in 13 years it has happened. The previous times were July 2012 and June 2020, each one in a period of economic distress.

“Loans that are below $50 million in outstanding balance have historically had a higher delinquency rate, but the July 2023 print shows that loans that are greater than or equal to $50 million have a greater rate of delinquency,” the report noted. And this time, there is no apparent recession to trigger the problem and it is also unlikely that delinquencies have reached their peak.

One issue has been loans reaching a maturity date without being able to secure financing, because for the first time in more than 13 years, interest rates shot up quickly and significantly, all in an attempt to chill inflation. The higher rates have pushed many properties into a situation where owners will either have to add significant equity, sell, or turn a property back to the lender.

An example of the dynamic for larger loans is the Rosslyn Office Portfolio, which was “transferred to the special servicer in May, and it currently has a non-performing matured balloon status,” Trepp noted. “The loan has suffered from weak financial performance at the properties within the portfolio. In a 12-month period from April 2022 to March 2023, DSCR (NCF) was 0.96x when occupancy was 75%. Rosslyn is one of several office loans above $50 million in outstanding balance that have reached their maturity date with no payoff.”

But even taking out large SASB loans, there’s still a pattern showing that larger loans are doing more poorly than smaller ones.

“We expect this trend to continue – smaller office loans muddling through and bigger loans entering CMBS purgatory at a higher rate,” the firm says.  “If the thesis holds true, CMBS investors might see better credit performance (and perhaps pricing) from conduit deals backed by smaller loans than by deals backed by SASB loans or by conduit deals backed by bigger loans.”