Cracks in the Commercial Property Market Are Widening to Apartments

(Bloomberg) — The cracks in the commercial real estate market are widening from offices to apartment complexes, with more than $67 billion of the housing potentially distressed as borrowers struggle to repay loans extended during the height of the pandemic.

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That’s potentially bad news for lenders like Arbor Realty Trust Inc., which focuses on packaging its floating rate loans into commercial real estate CLOs, a financing strategy that boomed in popularity during the pandemic. The share of loans in Arbor’s CLOs that failed to make a scheduled payment more than doubled in the fourth quarter, according to preliminary data compiled by Banco Santander SA. About 16.5% of Arbor’s unpaid loans by value were past due in December, according to the data, about 2.5 times the level for the wider CRE CLO market.

“Collateral performance in CRE CLOs deteriorated throughout 2023 with stress and delinquency rates rising sharply the final two months of the year,” Mary Beth Fisher, a senior fixed income strategist at Santander, said in a note last month that discussed the overall market. The trend is likely to continue through the middle of 2024, she said.

Paul Elenio, chief financial officer at Arbor Realty, said the firm is currently in a quiet period as it readies to release year-end results later in February.

“As our investors are aware, we have been very consistent and transparent in our messaging over the last several quarters and remain comfortable with our public statements and market guidance,” Elenio said. “We look forward to updating the public with our year-end earnings release.”

Apartment building financers were caught out by the sharp tightening in monetary policy because they often extend so-called bridge loans, which have floating interest rates. Lenders such as Arbor are hit if the borrowers eventually default because they provide the equity portion of the CLOs — the riskiest part of the securitization — while selling on the safer tranches, meaning they are the first to suffer losses if the loans aren’t repaid.

Concerns over commercial real estate reemerged this week after New York Community Bancorp and Japan’s Aozora Bank Ltd. were forced to set aside more money to deal with souring commercial property loans. Broadly put, rising interest rates are translating into lower property values that force investors to take losses, similarly to how rising yields depress bond prices.

Potential Distress

As interest rates plunged when the Federal Reserve responded swiftly to pandemic turmoil, lending to apartment complexes and bundling those loans into CLOs emerged as a popular investment. The dollar value of loans bundled into new CRE CLOs, including apartment buildings, surged from $19 billion in 2019 to $45 billion in 2021, according to data compiled by Bloomberg. The share of loans late to make payments across the vehicles plumbed lows around 1-3% from 2021 to 2023, according to the data compiled by Santander.

That trend came to a halt when borrowing rates began to rise. New supply, slowing revenue growth and higher expenses are also adding to the pain, with the multifamily delinquency rate for commercial mortgage-backed securities expected to double this year to 1.3%, Fitch Ratings forecasts.

More than $20 billion of apartment complexes purchased in the past three years are potentially distressed, according to MSCI Real Assets, a figure that more than triples when including buildings that haven’t changed hands recently.

“Owners who made purchases at record-high prices may have found their assets landing on servicer watchlists as assumptions used to underwrite their acquisitions proved overoptimistic,” the financial data provider said in a report last month.

Blackstone Inc., meanwhile, is weighing adding more multifamily assets amid the emerging problems.

“It’s possible you could see us invest into the weakness in multifamily because we’ve got a long-term constructive view, even if there are some near-term headwinds,” the company’s Chief Operating Officer Jonathan Gray said on a call with analysts last month.

Still, the amount of new potential distress in apartment complex rentals seems to have moderated in recent months, according to the MSCI Real Assets report, as the outlook for borrowing costs improves. Traders expect the Federal Reserve to cut rates by as many as six times this year, a boon for landlords.

Short Sellers

Uniondale, New York-based Arbor has been the target of at least two short seller reports, including one in November by Viceroy Research, which argued that the lender is burdened with distressed loans.

Short interest in the firm stood at almost 31% on Wednesday, according to data compiled by S&P Global. Short sellers borrow stock and sell it, betting they can profit by buying it back at a lower price later.

Arbor had about $7.3 billion of collateralized loan obligations outstanding last year, representing almost half of its capital stack, according to an investor presentation published in May.

–With assistance from Charles Williams.

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