Offices Aren’t the Most Threatened Real Estate Sector—Apartments Are

The woes of office buildings get a lot of attention: Near-empty downtown towers, with so many employees working from home, could end up defaulting on their loans, with horrible consequences for real estate investors.

But there is an even bigger menace in commercial real estate, according to a Morningstar research paper: multi-family, which comprises the largest real estate category, at 18.5% of market value (compared with 15.5% for offices). “Real estate loans in this area are looking especially wobbly,” wrote the report’s author, Madeline Hume, a senior research analyst at Morningstar Research Services, a subsidiary of the research giant.

How come? A large number of apartment developers took out loans in 2021, when interest rates were cheap. Unfortunately, Hume found, rates have climbed a lot since then, and multi-family loans reset after just two or three years.

As a result, Hume warned, “property developers for multi-family units are just now about to enter the gauntlet of higher rates.” This means “an $8 billion tsunami of multi-family commercial mortgage-backed securities—or CMBS, for short—is expected to come due, starting in the second half of this year. Some in the real estate market are calling it the Red October.”

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What’s worse, she continued, much of the lending comes from regional banks, which are facing problems staying afloat. These lenders, Hume contended, “are likely to be in no mood to make accommodations or take concessions; they want their money back.”

On the plus side, Hume went on, most CMBS are guaranteed by agencies such as Fannie Mae, Freddie Mac and Ginnie Mae. Thus, even if the loans default, one of these agencies will make investors whole, eventually.

Of course, such turbulence likely would take a while to be resolved, and a bunch of apartment buildings would be left in limbo. Asset allocators that have equity positions in multi-family would be left with problem properties on their books.

Hume noted that the “most glaring areas of stress, like downtown offices, are not always where the biggest dollars are at risk.”