Commerical real estate outlook for 2024

A National Bureau of Economic Research paper warned commercial real estate loan defaults could reach Great Depression-era levels if rates stay high. USC Finance Professor Erica Jiang discussed the risks on Yahoo Finance Live.

Jiang noted falling property cash flows, declining values, and refinancing challenges raising distress, especially for offices, multifamily, and hotels. She says "rising interest rates make it very difficult" to refinance, causing rollover issues.

With 15% of commercial loans already underwater presently, Jiang notes default outlooks now "don't look very good." She highlighted offices as particularly exposed, with 45% of office loans underwater, meaning the property value is below the loan amount. This makes refinancing unlikely as it "has high default risks."

For more expert insight and the latest market action, click here to watch this full episode of Yahoo Finance Live.

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- A new paper out from the National Bureau of Economic Research. It's coming out this month about the risks of commercial real estate loans on bank balance sheets. The report indicating that if interest rates do remain elevated and property values do not recover, default rates could reach levels comparable or even surpassing those seen during the Great Recession.

For more on the commercial real estate cliff, we're talking to one of the authors of that paper, Erica Jiang, who is USC Marshall School of Business assistant professor of Finance and Business Economics. Erica, thank you so much for joining us.

This paper caught my eye. This has been a big topic of discussion whether CRE on bank balance sheets was going to be a problem. What are the key things that you are watching? What is the situation as it stands here in terms of the status of commercial real estate?

ERICA JIANG: Great. Thank you so much for having me. There are several reasons why CRE has been viewed as having an elevated distress risk. On the one hand, the commercial real estate faces increased business risk that decreases the fundamental values of properties.

For example, the office properties are under significant pressure due to remote and hybrid work patterns. And the lower demand for offices can also negatively impact the demand for other commercial real estate properties like urban, retail, multifamily, and also hotels. And on the other hand, rising interest rates make it very difficult to refinance their loans, which increases the financial risk of CRE.

And most of the commercial real estate loans are going to mature in the next few years. And declining property valuation and rising interest rates make it very difficult to roll over the debt, which could lead to maturity default, which is the focus of the first part of the paper you saw.

- Erica, first of all, go Trojans. But second, I do want to talk to you about that debt rollover because I'm curious. And you talk about 15% of CRE loans underwater. 45% of those are office loans. Are those loans coming due going to be the catalyst that bursts the CRE bubble?

ERICA JIANG: Yes. So if we look at all of those CRE loans, and if we measure the default or the potential default risk using two important measures of distress risk, loan to value ratio and debt service coverage ratio, they don't look very good. I can give you some numbers if you are interested in the specific numbers.

- Sure. Give us some numbers, Erica.

ERICA JIANG: Yeah, so the loan to value ratio or LTV can tell us whether a loan is underwater, right? So in other words, what are the market value of the property is lower than the outstanding loan amount. And we know that the underwater loan is very difficult to refinance and faces high fall risk.

We find using loan level data is about 15% of all commercial real estate loans are underwater. And among all types of commercial real estate properties, the office loans face particularly high distress risk. And about 45% of office loans are underwater like what you just mentioned.

And if we compute the debt service coverage ratio, which tells us whether a property's annual cash flow is sufficient to cover its debt obligation, we can look at whether the property's cash flow is sufficient, right? And so the average debt coverage ratio was about two to three when those loans were originated a couple of years ago.

And we know that if this ratio falls below 1, it means the property does not have sufficient cash flow to meet its annual debt payments. And we find more than 6% of the CRE properties with the debt service coverage ratio below 1 by the third quarter of this year. And this is due to the declining property cash flows and rising interest rates on certain loans with adjustable rates.

So this calculation is still just based on the interest rate the CRE property operators received a while ago when interest rates were still very low and when their property values were still high. And we actually find a much higher risk if we think about refinancing difficulty.