Lender portfolios of foreclosed and seized office buildings, apartments, and other commercial properties grew 13% in the second quarter, as the slow return of workers to office buildings has helped push commercial-property distress to near historic levels.
Banks and other lenders are seizing control of distressed commercial properties at the highest rate in nearly a decade, indicating that the sector’s severe downturn is progressing toward its next phase and may be approaching a bottom.
In the second quarter, portfolios of foreclosed and seized office buildings, apartments, and other commercial properties reached $20.5 billion, according to data provider MSCI. This figure represents a 13% increase from the first quarter and the highest quarterly amount since 2015.
Defaults and other forms of distress have been steadily accumulating in the commercial-property market, driven by high interest rates and the slow return of workers to office buildings. Until recently, many lenders have been hesitant to take over properties, hoping for a market recovery and wishing to avoid the expenses and losses associated with foreclosure actions.
“Lenders will do everything in their power to avoid that,” said Jade Rahmani, an analyst at Keefe, Bruyette & Woods.
However, distress is making its way through the financial system as more lenders acknowledge that obsolete office buildings won’t regain their former value, even if interest rates decline. This realization is leading to sales of foreclosed properties and distressed mortgages and an increase in short sales, where lenders and borrowers collaborate to sell troubled properties for whatever price they can get.
While commercial-property values could deteriorate further if the U.S. economy falls into recession and companies reduce office space, similar surges in foreclosure activity during previous downturns have signaled the approach of a market bottom. Once lenders seize a property, they are typically quick to sell it, a process that helps establish property values after prolonged sluggishness in the sales market.
Office Buildings: The Most Troubled Property Class
Office buildings are the most troubled property class. In the second quarter, the volume of office properties seized in foreclosures and other actions increased by about $5 billion compared to the second quarter of 2023, MSCI reported. Apartment buildings, affected by rising interest rates and a surge of new supply, saw a $975 million increase in seized properties during the same period.
For example, KKR Real Estate Finance Trust recently seized a five-building Silicon Valley complex owned by a venture of Goldman Sachs and TMG Partners. The KKR unit, which held a $200 million mortgage on the property, took title at the end of June in a deed in lieu of foreclosure transaction and is expected to start marketing it soon after upgrades.
Numerous office buildings have sold at steeply discounted prices in Washington, D.C.’s struggling office market. This trend has made it challenging for lenders to maintain distressed loans on their books at their original values. For instance, State Farm Life Insurance recently conducted a foreclosure sale of an office building a few blocks from the White House for $17.6 million, over 70% below what the owner had paid in 2010.
The Role of Small Banks
Small banks, particularly those with assets under $10 billion, have significantly increased their foreclosure activity. In the first quarter, the total amount of seized commercial properties they owned rose by about $125 million to $943 million, the largest quarterly increase since 2000, according to bank-data consultant Matthew Anderson.
Even if the market is nearing a bottom, the commercial property industry is expected to experience prolonged pain. Much depends on whether the Federal Reserve begins to cut interest rates, a move anticipated by many in the fall.
However, a rate cut won’t benefit landlords who own obsolete office buildings that may never regain their lost value. “Risk in commercial property will be with us for some time, probably for years,” said Fed Chairman Jerome Powell in Senate testimony earlier this month.
Regulatory Concerns and Investor Responses
Regulators are concerned about distressed commercial real estate due to its potential ripple effects through the financial system. Debt maturities are expected to rise, with over $2.2 trillion coming due between this year and 2027, according to data firm Trepp.
Signature Bank, which had high exposure to commercial property, failed last year, leading to its assets being sold by the Federal Deposit Insurance Corp. This year, investors have made substantial cash infusions into other banks with large volumes of commercial real estate loans, such as First Foundation and New York Community Bancorp. The latter’s shares dropped more than 3% on Thursday after disclosing another quarterly net loss and preparing for further trouble in commercial real estate lending.
Many creditors are also experiencing a sharp increase in problem loans, often a precursor to foreclosures. Blackstone Mortgage Trust, with significant exposure to office loans, recently cut its dividend and increased its loss reserves by 19% to over $900 million. This month, the delinquency rate of office loans converted into securities rose above 8% for the first time since November 2013, according to Trepp.
Looking Ahead
So far, foreclosures and other property seizures remain well below levels seen during the 2008-09 financial crisis. In 2013, the total amount of foreclosed and seized properties held by lenders soared to over $45 billion, more than double today’s amount, according to MSCI. The current downturn might not reach such heights because office-building owners are more likely to give up and walk away from their properties than they were during the financial crisis. Back then, lower interest rates and a belief in market recovery led investors to hold on to their buildings.
These days, owners increasingly recognize that demand levels for their buildings won’t return. Many are opting for short sales, which are typically not counted as foreclosures. The volume of commercial property sales involving lender participation soared 83% in the first and second quarters of 2024 compared to the previous two quarters, according to Ten-X, a major online auctioneer of commercial property.
“This cycle, a lot of investors believe office values are challenged,” said Nicholas Seidenberg, managing director at the real-estate investment banking firm Eastdil Secured. “They’re saying: ‘Hey, I’m going to just walk away and not fight.’”
