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Pace Of Distress Slows As Banks Try To Work Out What Lies Beneath

From New York to Tokyo to Munich, banks last week reported bigger-than-expected losses related to distressed U.S. commercial property loans, raising fresh fears that the pain being felt in the country’s office market could cause systemic problems for the global financial system even as the pace of loans becoming distressed starts to slow. 

The situation leaves lenders, real estate investors, financial markets and policymakers trying to figure out whether the worst of loan distress is already behind it or if significant hidden nasties might yet rear their heads. 


A recent report from MSCI laid bare the extent to which lenders are facing a sharp increase in distressed loans. The volume of such loans skyrocketed by 51% to $85.8B in 2023, according to the data provider’s U.S. Distress Tracker, a $28.9B jump.

The tracker defines distress as announcements of bankruptcy, default and court administration as well as publicly reported issues, including significant tenant distress or liquidation. It also counts CMBS loans entering special servicing. 

Rising interest rates have caused the value of real estate in almost every asset class to fall, making loans underwritten when rates were at historic lows difficult to refinance. Values in sectors like office have been impacted even further because demand has fallen for all but the best spaces. 

MSCI categorizes a further $234B in loans as having the potential for distress, a measure of possible future property-level financial trouble due to delinquent loan payments, forbearance, slow lease-up/sell-out and other factors.

That $234B number represents the gray area for lenders when it comes to potential losses on CRE lending. Those loans might tip over into full-blown distress that hits values hard enough that they fall below the level of the loan, causing lenders to take a loss. But they could also see more equity injected to enable a refinancing, sale or extension until rates begin to drop, never tipping into the distressed category.

What's clear is that existing distress and potential distress are not evenly distributed among asset classes. MSCI’s data showed that office has by far the highest concentration, accounting for $35B of distressed loans, followed by retail at $21B and hotels at $14B.

But when it comes to potential distress, the apartment sector has the highest concentration. Some $67B of loans are seeing pressure of some sort, and MSCI flagged that 30% of it is tied to loans made in the last three years. The numbers suggest the rush into the rented residential sector that followed the start of the pandemic, when values were at their highest, has stored up potential future problems. 

In the office sector, there are $54B of potentially distressed loans, with $35B each in the retail and hotel sectors, MSCI said.

As for potential future losses for banks, MSCI has another data point to ponder: The pace of loans heading for trouble is slowing. Net new loans falling into distress in the fourth quarter of 2023 was $4.2B — a significant number, but lower than the $9B seen in Q3 and the $8.7B in Q2. 

About $200B of loans fell into distress in 2010 in the wake of the financial crisis, indicating that while the current level is above the historical average, it remains far below the last crisis. 

Worries about systemic issues in the financial system flared last spring, when the failure of Silicon Valley Bank, Credit Suisse, Signature Bank and First Republic disrupted financial markets. Some of those banks had large real estate loan portfolios, but none of their failures were specifically caused by real estate.

Last week, though, real estate came under the microscope when New York Community Bank reported a $252M loss related to loans for office and regulated multifamily properties. 

The bank also dramatically increased its estimates for unrecoverable debts to $552M, a 790% increase from the previous quarter’s $62M. NYCB's shares dropped by more than a quarter.

The drop raised alarms that other regional U.S. banks might be sitting on unexpected losses due to real estate loans, especially since smaller U.S. banks have ramped up their exposure to the sector in the past decade.

Those fears were not restricted to the U.S.

In Germany, Deutsche Bank said two weeks ago that it had set aside $133M during Q4 2023 to guard against potential defaults on its U.S. commercial real estate loan book, a fourfold increase on the same quarter in 2022.

Fellow German lender Deutsche PBB, a real estate specialist, said that it had upped its loan loss provisions due to its U.S. office exposure but expected to remain profitable. In a note on the bank, Morningstar DBRS said it anticipated the bank would make bigger losses as more U.S. loans defaulted, though not enough to affect the bank’s solvency. 

Effects are being felt as far away as Japan, where last week Aozora Bank reported its first loss in 15 years when it made a $214M provision to guard against losses on U.S. office loans.

Related Topics: MSCI, U.S. banking distress