Office CMBS Delinquency Soars to 10.4%: A Crisis Unfolds Again!

The trend of converting office spaces into residential areas is on the rise, but the reality is, only a fraction of these towers are suitable for such transformations.

By an industry expert

November marked a concerning milestone: the delinquency rate for office mortgages, which have been bundled into commercial mortgage-backed securities (CMBS), surged by a full percentage point for the second consecutive month, now sitting at 10.4%. This figure is alarmingly close to the peaks witnessed during the Financial Crisis, where delinquency rates for office CMBS reached a staggering 10.7%, as reported by industry analysts.

In just two years, we’ve seen an 8.8 percentage point jump in office CMBS delinquency rates—outpacing even the darkest two-year span of the Financial Crisis, which saw an increase of 6.3 percentage points.

The commercial real estate office sector is experiencing a profound downturn. Despite optimistic claims from prominent players in the industry suggesting that we’ve hit rock bottom, recent developments serve as a stark reminder of the challenges ahead:

As vacancy rates reach unprecedented levels across America, countless landlords are halting their mortgage payments. With rent revenues insufficient to cover interest and operating costs, refinancing options are evaporating as many older office towers have seen their property values plummet—some by as much as 70% or more. In fact, certain buildings have lost nearly all their value, now worth only the land beneath them.

What constitutes a delinquent mortgage? It’s when a landlord misses the interest payment after a 30-day grace period. Interestingly, a mortgage isn’t flagged as delinquent if the landlord keeps up with interest payments but defaults when the principal comes due. If we included these repayment defaults, the delinquency rate would be even higher.

Mortgages are removed from the delinquency list when interest payments are made or through foreclosure, often resulting in significant losses for CMBS holders. Additionally, some landlords may negotiate with special servicers handling CMBS to restructure their loans, an approach that often prolongs the inevitable issues into 2025 and beyond.

Among various sectors in commercial real estate, the office segment is facing the harshest reality with its 10.4% delinquency rate—outstripping lodging (6.9%), struggling retail (6.6%), and multifamily housing (4.2%). In stark contrast, industrial sectors, like warehouses, thrive with a mere 0.3% delinquency rate, fueled by the ongoing ecommerce boom.

But this isn’t just a temporary dip. The challenges facing office real estate are structural, stemming from an overabundance of outdated office buildings. Years of overbuilding and the misconception of an “office shortage” led to an excess of unused space. The pandemic drastically altered perceptions, as businesses recognized that much of this space was no longer needed, contributing to the oversupply.

The 2024 mantra has been a simple yet desperate one: “survive until 2025,” driven by hopes of significant interest rate cuts from the Federal Reserve to revive the market.

Many commercial loans are tied to floating interest rates, which are influenced by short-term benchmarks like SOFR. Lowering interest rates could breathe new life into some properties.

Although the Fed has made some cuts, its short-term rates still hover between 4.5% and 4.75%, with SOFR currently at 4.57%. Amid ongoing speculation, the rise of long-term rates due to inflation fears complicates the outlook.

However, no calculated rate reductions can address the deep-rooted issues plaguing office real estate. Owners of nearly vacant older office buildings will struggle to meet their obligations, regardless of lower rates.

And the ongoing “flight to quality” only exacerbates the situation. With high vacancy rates in newer buildings, companies are understandably migrating from outdated structures to modern facilities, often downsizing in the process, which accelerates the decline of the older towers.

While conversions of old office towers into residential units are gaining traction, the numbers remain disappointingly low. Many buildings are not conducive to conversion due to their design or the high costs involved, making demolition a more viable option than renovation.

In 2019, the U.S. saw 56 office buildings transformed into residential spaces. This trend continued with 63 conversions in 2023 and is projected to rise to 94 completions in 2025, with another 185 planned—bringing the total to 279 conversions.

Currently, there are 71 million square feet of planned or ongoing conversions, but this is merely a drop in the ocean compared to the staggering 902 million square feet of vacant office space nationwide, as estimated by industry experts.

Fortunately for the stability of the U.S. banking system, much of the risk tied to office mortgages is dispersed among global investors and foreign banks, not solely American institutions. For years, the assumption was that real estate, especially prime U.S. office spaces, was a surefire investment—leading to a global influx of capital.

Office mortgages are held by a diverse array of investors, including bond funds, insurance companies, REITs, private equity firms, and foreign banks, mitigating the potential impact on the U.S. banking sector.

While U.S. banks have some exposure to office mortgages and have faced significant write-offs, the call for “survive until 2025” persists. Although some smaller banks are grappling with concentrated office mortgage portfolios and may face daunting losses, they have thus far managed to stay afloat.

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