Cracks in the Armor?

In past Market Monitor editions, we have discussed some of the harbingers of emerging distress within the commercial real estate market. We continue to keep a watchful eye on increases in commercial real estate loan delinquency rates reported by the St. Louis Federal Reserve as a key marker of future distress.

Data posted by the Fed showed second-quarter delinquencies increased nominally to 1.26% from 1.22% in the first quarter. This certainly does not set off any alarm bells. But over the past quarter, we have seen a handful of opportunities to provide capital via preferred and joint venture equity for existing assets that represent a 20% or more discount to prior peak trades. These opportunities don’t represent a full sale and often don’t show up as recorded “sales comps” in the marketplace, so this information is not as widely captured by third-party appraisers or outside market observers. However, these limited and sometimes opaque data points provide early indications of where private real estate values are settling.

Our proprietary suite of machine-learning models, Origin , analyzes nearly 3 billion pieces of unique data per month to power our rent-growth projections (read our latest rent growth accuracy report here). The two most important variables in that model are apartment supply and renter affordability. While the increase in new apartment deliveries is well documented, one of the lesser-discussed trends that we are observing is the increase in consumer debt delinquencies. This basket of debt includes everything from mortgages to credit cards to auto loans. As of Q2 2023, it was 2.4%, up from the Q4 2021 low of 1.5%. For context, this rate was 2.3% in Q4 2019 and spiked at 2.5% in Q1 2020, a six-year high, right before the massive COVID-19 relief and stimulus packages were approved and distributed.

The stimulus caused those delinquencies to plummet in 2021. However, with 30-year highs on credit card rates (nearly 21% today), 23-year highs on mortgage rates (nearly 7.2% today) and a decline in personal saving rates to 4.5%, which averaged over 7% in the decade leading up to COVID, peaking at 26% in Q2 2020 (thank you, stimulus!), there is rising concern around renter affordability. With no other consumer stimulus planned, we believe that these factors will cause another crack in the armor of property operating fundamentals. An increasingly strapped consumer likely translates into some combination of decreases in occupancy, increases in rent concessions and increases in delinquent rent payments that could show up over the coming months.

Delinquency Rate on Consumer Loans, All Commercial Banks

Source: Board of Governors, U.S. Federal Reserve System

If the previously discussed uptick in transaction volume manifests over the coming quarters and is further combined with a deterioration in underlying fundamentals, we believe that these opportunities will increase. That said, it is apparent that many of the larger commercial estate lenders are taking proactive measures to stem the tide of distress. According to second-quarter earnings calls, a significant number of U.S. commercial banks continue to pad loan loss reserves, largely in anticipation of impending office loan maturities. As an example, Wells Fargo increased its provisions for credit losses in the second quarter by nearly $1 billion, primarily to address distressed commercial real estate loans, along with higher credit card loan balances.

These actions by some of the largest commercial estate lenders in the country suggest that they are preparing to work with borrowers to restructure existing loans. In doing so, these lenders would write off some outstanding loan balances to address the decline in market values and extend loan maturities to allow operating fundamentals to improve. These restructurings will require capital infusions of many sizes—some of which will favor smaller capital providers that can fund investments of less than $5 million. As such, questions remain around the true scale of distressed opportunities that will be available in the market.

While the body armor of the marketplace is largely intact and lenders appear ready and able to address some of the impending distress, we remain optimistic that we will continue to find quality, risk-adjusted opportunities for our capital.