Commercial real estate loan credit trends to worsen: Fitch

December 26, 2023 (MLN): Credit trends in commercial real estate (CRE) loans are expected to continue to deteriorate through 2025 for commercial mortgage-backed securities (CMBS), U.S. banks, and life insurers, but losses should remain within ratings sensitivities, Fitch Ratings said in its latest report.

Deterioration will be led by office properties, with weakening also expected across retail, hotel, multifamily, and industrial properties.

For U.S. CMBS, Fitch expects the greatest decline in property net cash flows from office and non-trophy malls as growing macroeconomic headwinds and high-interest rates lead to increased maturity defaults.

Fitch forecasts overall U.S. CMBS loan delinquencies to double from 2.25% in November 2023 to 4.5% in 2024 and 4.9% in 2025.

The U.S. CMBS office delinquency rate rose 64 bps in November, the largest increase since June 2020, to 3.48%.

The majority of the $1.59 billion in new U.S. CMBS 60+ day loan delinquency volume in November comprised office and multifamily.

Fitch forecasts U.S. CMBS office loan delinquencies to jump to 8.1% in 2024 and 9.9% in 2025 and for U.S. CMBS multifamily loan delinquencies to increase from 0.62% in November 2023 to 1.3% in 2024 and 1.5% in 2025.

The bifurcation of office CRE performance will continue. Office CRE in larger central business districts (CBDs), particularly older vintage product, is highly vulnerable as the structural shift to hybrid working has reset valuations, making refinancing more challenging, especially for CRE with tenant rollover and/or lower debt service coverage ratios.

Fitch expects continued negative net operating income growth for office properties in 2024, with lower quality urban office properties most affected.

The national office vacancy rate is 13.5%, up from 9.5% at YE19.

Additional sublease vacancies and lower tenant office needs drive the total availability rate to 16.6%, an all-time high, up from 12.2% at YE19.

It expects the national office vacancy rate to increase to 15.7% by YE24 and 16.6% by YE25, and current market rents to decline 3.3% by YE24 and an additional 2.2% by YE25.

The top metropolitan areas by asset value with current vacancy rates above the national average are San Francisco (20.3%), Houston (19.2%), Dallas/Ft. Worth (19.0%), Chicago (16.1%), Washington DC (15.8%), Los Angeles (15.6%) and New York (15.1%), while average transaction sales prices also declined for most of these cities.

Starting in mid-2022, Fitch raised office cap rates by 100 bps, on average, higher than issuance on B quality and lower properties.

Fitch’s property-level office net cash flow analysis also factors in higher tenant improvement costs, lower renewal probability, markdown of above market rate leases rolling during the loan term and places additional consideration on market availability rates when determining vacancy assumptions.

U.S. life insurers’ CRE exposure is largely comprised of diversified, high quality investment portfolios, with conservative underwriting, strong liquidity, and effective asset-liability management.

Life insurers’ exposure is largely in commercial mortgages, with CMBS representing less than 5% of cash and invested assets and a non-meaningful allocation to equity real estate.

Mortgage loans comprised 13% of U.S. life insurers’ portfolios, or 1.6x capital, at YE22, above historic levels of 8%-12%, but stable yoy.

Fitch expects for losses to emerge, but insurers have ample capital to absorb higher losses, and are generally well positioned given their conservative underwriting, diversified portfolios, and strong track records across multiple cycles.

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