Single-Asset, Single-Borrower Bonds No Longer Look So Safe

Investors in commercial real estate could be forgiven for thinking they have found themselves on the set of The Big Short. In particular, that scene with Ryan Gosling with a Jenga tower as he explained how mortgage-backed bonds had changed — turned into a private game of three-card monte.

Things are changing now. In May came the news that investors in the AAA tranche of the $308 million debt backed by 1740 Broadway in midtown Manhattan only got 74% of their investment back after the loan sold at a steep discount. That was the safe tranche. Creditors in the five lower groups were wiped out.

Now, the Wall Street Journal reported that another part of the CRE-backed bond market is seeing more defaults than was ever supposed to. The single-asset, single-borrower (SASB) bond market — an estimated $260 billion worth — is feeling the tremors. The loans backed the purchase of major office and retail assets. The investors are institutional investors like pension funds, insurers, and banks.

The reason for the shift is simple. Ratings happened once upon a time when interest rates were lower and allowable underwriting leverage was much higher. Many face the prospect of upcoming maturity and the need to refinance when they can’t find a lender. The Journal quoted data from the CRE Finance Council that said the rate of loans at or near default has grown to 8.7% in 2024, nearly triple since 2022.

Research from the Federal Reserve Bank of Philadelphia showed a fundamental change in the CMBS market. Once dominated by long-term, fixed-rate securitizations that financed a quarter of the CRE market, by 2021-2022, the major vehicle was short-term, floating-rate SASB securitizations. The researchers said that the factors that made SASB show superior performance have weakened.

Low rates initially allowed SASB loans to adopt floating-rate financing. Rating agencies that handed out AAA ratings never considered the possibility that property prices would fall below the loan price, making them vulnerable to rapid and sizeable rate changes. And then came inflation and upward moves of interest rates.

“When the pandemic gutted demand for offices, private-equity firms abandoned near-vacant buildings and their debts, leaving bondholders holding the bag,” the Journal wrote. There are already SASB bonds in default on shopping centers and offices.

As debt comes due on more properties that were barely getting along, more will likely default. The more turmoil, the more bond investors will become wary of such arrangements, which becomes a disruption in CRE markets.