Commercial Real Estate Mastery: Episode 40
The Current “Debt Apocalypse” Stats
As the U.S. commercial real estate market navigates one of the largest debt challenges in modern times – brought on by both structural changes in American society as well as the rapidly ascending interest rates beginning in 2022 – the stats are starting to come in and put a spotlight on where the greatest weaknesses are. In this Commercial Real Estate Mastery podcast we’re going to explore what these early indicators are showing.
Episode 40: The Current “Debt Apocalypse” Stats Transcript
It's a fact that there's roughly $2 trillion of commercial real estate debt coming due, and this is called generically in the press the debt apocalypse, because people assume with that much debt coming due at a time when interest rates are so elevated that it can only lead to disaster. But there hasn't been a lot of data on it. People talk a lot about it, I've written articles on it. But the government doesn't really give you much oversight of what's really going on regarding the supposed debt apocalypse. We don't know if it's already happening or it's in the future. We don't even know the subset of properties that are most at risk. But recently some of the data started coming out. This is Frank Rolfe with the Commercial Real Estate Mastery podcast. We're gonna go over what this first run of data is showing on the debt apocalypse, what we can learn from that, and maybe what the opportunities are.
So the first observation I have from looking at the data is that mixed-use developments are the worst. 80% of all mixed-use developments right now are upside down, which means that the current value of the asset is lower than the amount of the debt. And that's a problem because most people put down 30% or so on those mixed-use developments. So the market right now would say that their 30% is gone and then some. So clearly mixed-use developments didn't turn out to be a very good idea. Now, I don't know why mixed-use developments, of all the things out there, are the weakest. Maybe because they include all these different items which are all doing terrible, which we're about to go over, all at the same time. Maybe the problem is you can be a jack of all trades and a master of none. Maybe people started doing mixed-use development who didn't really have the skill set to do it. I'm not sure. But when someone tells you, "Oh yes, I own a mixed-use development," well, you should just feel sorry for them because the mixed-use side at 80% upside down is atrocious. It's terrible.
Next up to bat is the worst loans going on right now, of course, are office buildings. We all know office buildings are screwed. You can see it every day when you drive around downtown. There's so much vacancy in those buildings. Many of the buildings are completely vacant. Others, if they're cleaning them at night with all the lights on in the building, you can see half the floors are empty. And we all know the reason for that. Simple reason is people don't really office like they used to. Many people work remote, many buildings have... Or companies have downsized, don't need as much space, and people don't want to really be in downtown areas anymore. They look at them as being crime-ridden. So the American office building is in a real predicament. And as a result, it's currently running 63% of all those loans are upside down, which means 63% of all office buildings right now are worth less than the amount of the debt. And that's really bad because America has many buildings, particularly in Manhattan, for example, you have buildings which are nearly $1 billion in value. So losses on that building can staggering be in the hundreds of millions of dollars.
Now this next one may shock you, and that's that apartments are right now 52% upside down. Okay, that's terrifying. So wait, what do we mean apartments are upside down? Well, just that, that the amount of the loan is greater than the value of the apartment in about half of the cases. Now why is that? Well, it's because people overpaid and they didn't take into account the rising interest rates. Remember that interest rates back in 2021 were less than half of what they are today. So the valuation of that apartment based on the cap rate, with those kinds of low interest rates, now cap rates pretty much doubled along with interest rates. So apartments are in trouble. Lodging is also right there with apartments, running about the same, little higher, 54% of those are upside down. We know why lodging is in trouble. That's simply the fact that Americans just don't travel for business like they used to. They're still traveling for fun, but if you look at the P&Ls of most of those hotels, it was all based on business travel. Those were the people that always tended to overspend. They rented the ballrooms, they bought food and liquor in abundance. And without that, it's really hard for apartments to survive. And clearly, with over half of them upside down, it's really questionable how many will survive.
And then you've got retail, and retail is in real trouble. Retail right now, 40% of all retail is upside down. Means the value of the retail center is less than that of the debt. And we all know why on that one. That one's easy. We all see the Amazon trucks running down the streets every day. That's the end of retail right there. Those little Amazon trucks spelled the end of it all. I'm as big a culprit as anybody. If I wanna buy a dehumidifier for the basement, I'm not gonna go out to the store and buy it and put it in the shopping cart and stick it in my car and pull it out of my car. No, I'm just gonna buy it online, have them deliver it right to my door. Plus, I don't have to spend the gas cost to drive out to the store, my time. So retail is kind of permanently ruined. I think we would all agree with that. I don't even know if it's really hit bottom. I think retail may still be going down, to be honest with you. We're seeing continual announcements of more stores closing. You probably saw recently that Dick's Sporting Goods is gonna close a bunch of stores. It seems like almost every week they're announcing more retail stores closing. And of course, the people who own the buildings those stores are in, they're in for a heap of trouble.
But now when we look more macro at what all this trouble tells us. Well, geography is a big culprit because of all the numbers I just gave you, the number one epicenter of all of the distress is New York. New York is so far ahead of everyone else in number one position, it's not even funny. Almost all of their office and lodging and apartments and retail, it's all upside down. After New York, number two position, the Mid-Atlantic. Number three position, California. Most of the map of real estate distress is in those three generic areas.
And then you look at the type of loan. 80% of interest-only loans are in trouble in the United States. That is huge, 80%. Those loans which were carrying principal and interest only represent 20% of loans that are in trouble. So there's some kind of tie-in between interest-only loans and being upside down. I think it was because the people who needed interest-only, because those deals were so shaky, the lenders probably should not have done that. They probably should have said, "Wait a minute, if you can't support a principal payment, I don't think we should be making that loan," but yet they did. Another problem with interest-only may be that they didn't have the benefit of paying down their debt over time, which would have strengthened them 10 years in so that they had needing a lower loan. But those loans never shrunk because they were only paying interest as they went. So what are the lessons learned from everything that we just discussed? Well, number one, lenders are gonna start moving away from the areas that scare them, the areas that are underperforming. So lenders are gonna start moving away from deals in New York, California, and the Mid-Atlantic states. That's just a fact.
And lenders are also gonna move away from industry sectors that are performing so poorly. They're not gonna want to make loans, obviously probably ever again on mixed-use. But office and lodging and retail and even apartments, they're not gonna be looking at those as favorably. There are other niches of real estate such as mobile home parks and RV parks. These things have almost no default. But the sectors where there is lots of default, people are gonna be less interested in doing it. It also once again represents that every time in our nation that we try and pretend that everything is a big old macro problem, it's never a macro problem. You gotta refocus on the micro. It's kind of a gaslighting that goes on, particularly in the states that are always doing poorly. They want to include everyone else into their problems by claiming it's a macro issue. But it's not. That's not just based on fact. Just look at the map. Look at the stats. Are there problems with commercial real estate lending right now? Yes. Will there be a debt apocalypse? Very possibly. Is it true across the spectrum? No, it's not. It's very narrowed down to just those troublesome little sectors. This is Frank Rolfe with the Commercial Real Estate Mastery Podcast. Hope you enjoyed this. Talk to you again soon.
