Macro

Losses Mount in AAA Bonds Backed by $308M Commercial Real Estate Debt

AAA Bondholders Face 26% Loss on $308M Note as Commercial Real Estate Market Hits Distress

By Barry Stearns

5/23, 08:51 EDT
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Key Takeaway

  • AAA-rated bonds backed by commercial real estate, like the $308 million note for 1740 Broadway, are experiencing significant losses for the first time since the financial crisis.
  • The delinquency rate for office loans in CMBS reached 6.4% in April, with $52 billion of office loans in trouble as of March.
  • Analysts predict further losses in top-rated CMBS tied to older office buildings and single-anchor tenants, signaling deep distress in the US commercial real estate market.

AAA Bondholders Face Losses

For the first time since the financial crisis, investors in top-rated bonds backed by commercial real estate debt are experiencing losses. The AAA portion of a $308 million note backed by the mortgage on the 1740 Broadway building in midtown Manhattan returned less than three-quarters of the original investment earlier this month. This marks the first such loss of the post-crisis era, according to Barclays Plc. Lower-ranking creditors were completely wiped out. The fact that losses have reached top-ranked holders, overwhelming safeguards designed to ensure full repayment, underscores the deep distress in pockets of the US commercial real estate market.

Bonds backed by single mortgages tied to older office buildings with one anchor tenant, like 1740 Broadway, are particularly vulnerable. Analysts predict further losses as more loans are sold at steep discounts. "Now that we’ve seen the first commercial mortgage-backed securities get hit, other AAA bonds are bound to see losses," said Lea Overby, a CMBS strategist at Barclays. "These losses may be a sign that the commercial real estate market is starting to hit rock bottom."

Rising Delinquencies in Office Loans

The share of delinquent office loans packaged into commercial mortgage-backed securities (CMBS) reached 6.4% in April, the highest since June 2018, according to Moody’s Ratings. About $52 billion, or 31%, of all office loans in commercial mortgage bonds were in trouble in March, up from 16% a year ago, according to KBRA Analytics. Some cities are facing more stress than others, with 75% of CMBS office loans in Chicago and 65% in Denver in jeopardy.

"Values have plunged because of the combination of rising interest rates, which means increasing investment, as well as decreasing cash flow," said Harold Bordwin, a principal at Keen-Summit Capital Partners. "The consequence is equity will have significant losses and secured debt holders, their investment is impaired."

Specific Cases of Distress

The 1740 Broadway building, formerly the Mutual of New York or MONY building, was bought for $605 million by Blackstone Inc. in 2014. Blackstone took out a $308 million mortgage, which was packaged into a CMBS. In 2021, L Brands, the former parent of Victoria’s Secret and Bath & Body Works, exited the tower, which occupied 77% of the property’s leased space. Despite Blackstone's efforts to modernize the building, tepid demand for office space made finding new tenants difficult. Blackstone defaulted on the loan in 2022.

Recently, the mortgage’s special servicer and Blackstone agreed to sell the building to Yellowstone Real Estate for roughly $186 million. The deal resulted in the repayment of the CMBS, but only $117 million was left for bondholders after additional losses from fees and advances. Investors in $151 million of lower-rated debt were wiped out, while those holding $158 million of debt originally rated AAA suffered a 26% loss. "This deal was a perfect storm of an office building that relies on one tenant for the majority of the rent," said John Kerschner, head of US securitized products at Janus Henderson.

Street Views

  • Lea Overby, Barclays (Bearish on AAA commercial mortgage-backed securities):

    "Now that we’ve seen the first commercial mortgage backed securities get hit, other AAA bonds are bound to see losses. These losses may be a sign that the commercial real estate market is starting to hit rock bottom."

  • Harold Bordwin, Keen-Summit Capital Partners (Bearish on US commercial real estate market):

    "Values have plunged because of the combination of rising interest rates, which means increasing investment, as well as decreasing cash flow. The consequence is equity will have significant losses and secured debt holders, their investment is impaired."

  • John Kerschner, Janus Henderson (Neutral on office space CMBS):

    "This deal was a perfect storm of an office building that relies on one tenant for the majority of the rent. We will see more bonds get hit related to the office space, but it’s going to take some time. Leases and office mortgages are very long-dated."

  • Tracy Chen, Brandywine Global Investment Management (Cautiously Optimistic on AAAs in specific cases):

    "It’s very rare for the AAAs to get hit... You have to be extremely cautious as the value of office buildings are less transparent due to lack of transactions, and so are the bonds tied to them."