Where Did $700B in Maturing CRE Loans Go? | Top of Mind Series

Welcome back to the Invest Like a Billionaire podcast. I'm your host, Ben Frazier, joined by co-host Bob Fraser. Today we got a top of mind episode talking about where did the $700 billion of loans that matured last year in the commercial real estate space go? We saw that there was this big distress in the system and what happened to the meltdown, man? I know, I guess we just made it through. I guess it just was no, no big deal, right? So what happened?

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Well, so appreciate the research of John Chang and Marcus Millichap, who we've had on the show a couple of times and we love very much, but basically doing the analysis under the hood of all these maturing loans The vast majority of these distressed loans, so these are loans that are troubled loans, bridge loans primarily, and they were originated in kind of the bubble of, you know, '21, '22 timeframe. What has happened is they've all been deferred. So it's exactly what we thought would happen. They're kicking the can down the road. So what it means to defer is they basically extend the loan. So instead of being due This year they give it 2 more years and maybe they drop the interest rate. Maybe they take some of the arrears of the loans and they tack 'em onto the principal. So they're doing basic extensions. The vast majority of these loans have been just punted. And it goes back to what Fitch said when, you know, a year ago we're quoting the Fitch stats that said that 25% of the loans that they've seen are distressed. but they believe the servicers are going to just manage that and not create foreclosures. So what no one wants to do, and these big lenders don't want to create a big liquidity crisis where everyone has to dump these on the market, and then they will take greater losses. So it's punting the problem down the road in the hopes that 2 years from now the market is stronger than it is today. It's not a bad strategy actually, right? It's just extend and let's put this problem off to a later day. And again, truly, if rates come down, you know, in a couple years, things will be better. And assuming that we also see the market, you know, we're seeing softness in rents, softness in vacancies, we're seeing increased expenses in insurance and of course mortgage rates. So if any of those things ease a few years from now, everything will be better, right? So then these properties will presumably get better.

Right. And it's something obviously we've talked about for a while now of just this kind of looming maturity wall with distressed loans. And it makes sense, right? Coming from the banking world, a lot of these, whether it's banks or bridge lenders, which I'll make a point here in a minute, but a lot of times the lenders, they don't want to take back the properties. That's not the ultimate goal because they're not generally operators, right? They want to lend and they want to get paid their interest rate and they want to get paid off down the road. And so a foreclosure is really the worst-case scenario for a lot of these lenders, and especially if it becomes a bigger issue like a liquidity crisis, like you're saying, where all of a sudden everyone's foreclosing, no one's buying. So you're taking even deeper losses because there's no market for buying these. And so it makes sense that they're extending. And as you just said, the hope is the market kind of recovers and turns and it's kind of the worst of all factors are hitting all at the same time. You just did a presentation a few weeks ago at a large conference in talking about some of the issues that the commercial real estate market and specifically the multifamily market is experiencing where rents are coming down because there's a whole bunch of new supply, especially in the Sunbelt markets. That's, you know, creating competition for tenants and rents are down, operating costs are significantly up, insurance costs, property taxes are being reassessed, just ongoing labor maintenance, property management. And then you've got increased debt service costs. So every single factor is squeezing these properties. But the hope is that kind of eases over time. The other kind of point I wanted to make, because we talked about this other day in our episode called The Banks Are Not Okay, and it was a little bit facetious because a lot of people assume that this is going to create a massive banking crisis. But a lot of these loans that are really struggling, the majority of them are bridge lenders, which are not traditional banks. These are usually private lenders, and a lot of times they will sell commercial collateralized loan obligations, so CLOs, and securitize these portfolios, but they're not traditional lenders that a lot of people think of as, you know, what are the ones financing these properties. So do you foresee if these maturities continue to hit and you can't kick the can down any further, we will see some impact to the banking system, but, you know, maybe not as severe as a lot of people might think.

We're not seeing distress in the banking sector for sure. We're seeing a few banks that are stressing. They're smaller banks. This really is not going to go systemic in a banking crisis. Real estate crisis are kind of normal. They happen all the time, but rarely do they turn into a banking crisis. And that's when it gets severe. When a real estate crisis turns into a banking crisis, you have a problem because the banks are the financial plumbing of the world. And so if the plumbing backs up, you got a big problem. And right now it's not happening. Banks are very, very healthy by and large. So it's really not a problem. So basically we saw '23, which was a big maturity year of troubled debt, especially, let's just talk about the multifamily space. Yep. Then you saw record deliveries of new apartment complex into the weakness. And so all that stuff was extended, pretty much most of it was extended. Not a lot of foreclosures happening. What's happening though is we got 2 more years of pretty massive maturities According to Numark, $159 billion in troubled multifamily. These are multifamily-only loans, and these are ones troubled. And what troubled means, they're not earning enough. So 38% of them, according to CredIQ, have a debt service coverage ratio below 1.25. What does that mean, Ben?

They don't make enough income to pay all their expenses and their debt and service the debt.

Is that a problem?

Big, big problem.

That means banks will not refi these loans and they can't get a new loan for it. So $159 billion maturing that can't afford the new debt. That does not include being at higher interest rates. And then 35% of them, these maturing loans had origination cap rates below 4%, means they were bought at the very top of the bubble and they massively overpaid for these. So we got 2 more years of this. Where we have even more deliveries happening. So 1 million doors of new apartments are being delivered and we have $159 billion in troubled debt maturing. So will they continue to extend? My guess is yes, they will continue to extend those loans, but they will at some point, they're going to start to just say, we're going to foreclose some of these. We've looked at a few distressed debt opportunities in our business. And these deals, one of 'em in particular we won't name, but there's no option for extending, right? You can extend all day long in this deal. It's never going to work.

The principal balance is higher than the current as-is value of the property.

And even if they finish executing their business plan, if they got, you know, fill me in bucks to finish executing their business plan, it still is unlikely to cover the senior debt plus the 3 or 4 million in capital they need to rejuvenate, right? It doesn't even cover it.

So what's the answer?

You extend that all day long. The problem is the basis is just too high.

Yeah.

And it's going to go to foreclosure at some point. So you can extend, but, and there's a lot of loans that are going to be like that. The servicers can extend in the hopes of, you know, kind of stupid money coming in to bail it out. But yeah, my guess is there's just got to be enough of those, you know?

Yeah. I 100% agree. And I think there's going to be a big spectrum, right? Of, like you said, that's probably one end of the spectrum where there's just, there's no way you're going to work out of this. And it's probably just putting good money after bad to continue to try to rescue this property in this market because the basis was just too high. And, you know, in real estate, you make your money on the buy, and if you bought too high, it's just very difficult to come out in front of that. There are other properties where it's on the edge. It can go either way, and it's not overleveraged or underwater in the sense of the loan's worth more than the property, or you might lose some equity, but it's not going to be a complete wipe or foreclosure. And then there's other deals where depending on what market you're in, you actually might see a big rebound in rent growth. One of the slides you had in your presentation, this is from Globe Street, actually, we could put this in the notes here, but the different markets and the kind of quartiles of markets on rent growth where the kind of bottom quartile of markets is expected in 2024 to have a -4% rent growth. And these are the really high supply markets. So these are right, Sunbelt markets. This is the Florida, this is Texas markets, this is Atlanta, Phoenix, where there's been a ton of new deliveries of apartments. And as expected, rent growth is going to likely be negative to bring tenants in. But the top quartile markets are actually expected in 2024 to have a 6% rent growth, right? So that's what's so important in all this analysis is not to lump everything together, right? It's sometimes helpful to understand the big picture going on, but then in real estate, not all markets are created equal and there's not one real estate market, right? There's lots of different real estate markets that perform differently based on the fundamentals. And so the Midwest, the Rust Belt, even the Northeast are actually predicted to positive rent growth. Well, I hope you guys are enjoying this episode. Any other things you guys want us to talk about in these Top of My episodes, please reach out and subscribe if you're not already subscribed. Leave us a review, share with a friend. Appreciate you listening. Stay tuned for more episodes coming up.