A recent paper from the National Bureau of Economic Research has raised concerns about the potential for commercial real estate loan defaults to reach levels comparable to the Great Depression if interest rates remain high. USC Finance Professor Erica Jiang delves into these risks.
Jiang points to several factors contributing to heightened distress risks in the commercial real estate (CRE) sector. Falling property cash flows, declining property values, and challenges in refinancing are particularly affecting offices, multifamily units, and hotels. The rise in interest rates is identified as a major hurdle, making it difficult for property owners to refinance and causing rollover issues.
Currently, 15% of commercial loans are underwater, and Jiang emphasizes that the default outlook does not appear favorable. Offices are particularly vulnerable, with 45% of office loans underwater, indicating that the property value is below the loan amount, making refinancing a high-risk proposition.
In a discussion with Erica Jiang, assistant professor of Finance and Business Economics at USC Marshall School of Business, the potential risks and challenges in commercial real estate are explored. The National Bureau of Economic Research paper warns that if interest rates remain elevated and property values do not recover, default rates could surpass those seen during the Great Recession.
Key Points:
- CRE faces increased business risk, especially in office properties due to remote and hybrid work patterns, impacting demand for various commercial real estate properties.
- Rising interest rates create difficulties in refinancing loans, increasing financial risk for CRE.
- With a significant percentage of CRE loans maturing in the next few years, declining property values and rising interest rates pose challenges in rolling over debt, leading to potential maturity defaults.
- Specific distress indicators, such as the loan-to-value ratio (LTV) and debt service coverage ratio, highlight the precarious state of many CRE loans. Approximately 15% of all commercial real estate loans are underwater, with a particularly high distress risk for office loans (45% underwater).
- The debt service coverage ratio reveals that over 6% of CRE properties face challenges in meeting annual debt payments due to declining property cash flows and rising interest rates.
The conversation underscores the need for careful monitoring of the commercial real estate market in light of these challenges, emphasizing the potential impact on loan defaults and the broader economic landscape.
