Behind the Numbers
Bloomberg Terminal users can click here for a detailed look into the mortgage-backed securities reviewed for this story.
For the first time since the great financial crisis, buyers of top-rated commercial mortgage-backed securities are suffering losses.
1407 Broadway was, as far as the financiers of Wall Street could tell, as rock-solid an asset as could possibly exist. Located in the heart of Manhattan’s storied Garment District, its entrance cut from white marble flecked with a soft bronze terrazzo motif, the 43-floor tower was a money-minting machine with a never-ending roster of well-heeled corporate tenants.
So when the owners floated a $350 million bond backed by the building’s rental income in 2019, the bulk of the debt was stamped with a AAA credit rating, the highest grade awarded by ratings firms. Not even US Treasury bonds, the North Star for global financial markets, are deemed that safe. But 1407 Broadway, the thinking went, was so impervious to the vagaries of economic cycles that a default was unfathomable — nothing more than a once-in-5,000 years kind of freak event.
On June 17 — four years and 212 days after the bond was issued — investors in the AAA rated chunk of debt were informed they wouldn’t be getting the full $1 million interest payment they were owed that month. They’re now foreclosing on the building to salvage whatever they can of their investment.
Over in Chicago, at a building called River North Point, it’s a similar story. So too at 600 California St. in San Francisco and at 555 West 5th St. in Los Angeles. Back in Manhattan, just a short walk down the street from 1407 Broadway, the default is official at the old MONY building. It was sold off at a fraction of its pre-pandemic price, fully wiping out some creditors and even sticking buyers of the AAA bonds with a 26% loss — something that hadn’t happened since the great financial crisis.
Of all the hot spots across global finance that were upended by the pandemic, few remain as fragile as the commercial mortgage-backed securities market. And within this market, the pain is most acute in a new breed of bonds, known as SASBs, that buildings like 1407 Broadway represent.
A Bloomberg analysis of almost every SASB tied to a US office property, more than 150 in all, revealed that creditors across numerous deals are on track to get only a portion of their original investment back. In multiple cases, the losses will likely reach all the way up to buyers of the AAA portions of the debt.
This is in large part because unlike conventional CMBS, which bundle together hundreds of property loans, SASBs are typically backed by just one mortgage tied to one building.
The pandemic exposed just how risky a concept this was. But back before lockdown and remote-work became everyday words, investors were blind to it. They believed the AAA ratings were valid and scooped up the SASB debt at such a frantic clip that it grew from almost nothing into a $300 billion market in a little over a decade.
“There will be deals that are horrific, where the AAAs may not be paid off in full and there’s basically no bid for the asset,” said TJ Durkin, head of structured credit and specialty finance at TPG Angelo Gordon. “The investment community thought the real estate would never become obsolete. It ended up being wrong.”
Bloomberg Terminal users can click here for a detailed look into the mortgage-backed securities reviewed for this story.
To be clear, the SASB market — and the CMBS market overall — have begun to rebound some.
While the losses pile up on the hardest-hit deals, demand for SASBs backed by newer buildings located in prime spots in the biggest cities is picking up. Sales of new SASBs have totaled $56 billion this year, nearly matching the kinds of numbers seen before the market seized up a couple years ago. “The commercial mortgage bond market is a world of have and have-nots right now,” said Lea Overby, a CMBS strategist at Barclays.
And there are nascent signs of stabilization among the have-nots, too. Prices on some distressed SASB deals have sunk to such depressed levels that bargain hunters are snapping them up. Ellington Management Group, Beach Point Capital Management, Balbec Capital and Mica Creek Capital Partners, a hedge fund that opened its doors this year, are all active buyers. Even Durkin at TPG Angelo Gordon is looking for spots to buy.
“We believe there are tremendous opportunities,” said Marcello Cricco-Lizza, a portfolio manager at Balbec, “but also meaningful pitfalls.”
It only takes a glance at the data to see where the dangers are greatest.
Numerous office towers that back so-called single-asset, single-borrower commercial property bonds have been reappraised at fractions of their former value.
Take Gas Company Tower. A skyscraper at 555 West 5th St. in Los Angeles, it was valued at over $630 million a few years ago. In March, that figure was down to just $215 million. Its owner, an affiliate of Brookfield Asset Management, ultimately handed the keys over to creditors, and recently Los Angeles County said it planned to buy the skyscraper out of receivership for no more than $200 million.
Another key measure Bloomberg tracked is what’s known in the industry as an appraisal reduction amount, or ARA. It is, in essence, a calculation to determine the extent to which a CMBS’ outstanding balance exceeds the property’s value following a new assessment, and is used to reduce or shut off interest payments to creditors at the back of the repayment priority line.
At 1407 Broadway in Manhattan, River North Point in Chicago and 725 South Figueroa St. in Los Angeles, appraisal reduction amounts of between $170 million and $226 million suggest that AAA bond buyers could suffer steep losses, while lower ranking investors may be wiped out if and when the buildings get sold.
Market watchers point out that appraisals can vary from the ultimate sale price of a building, and there are often additional costs that must be paid back before distributions to bondholders, making ARAs an imperfect predictor of losses.
There are other factors that could affect how investors in bonds backed by 1407 Broadway — from Lord Abbett to Palmer Square Capital Management and others — make out.
These include the fact that landlord Shorenstein leases the land that the building is built on, complicating any possible sale, and that Shorenstein and the special servicer, appointed to intervene on behalf of bondholders when a CMBS struggles, could still negotiate a loan modification that potentially benefits top-ranked creditors.
Not all struggling buildings have recent appraisals or ARAs. Creditor groups often have vested interests in delaying assessments to ensure they continue to receive interest payments, and even when completed, the new values aren’t always disclosed.
But bond prices often reveal the extent of the trouble. More than a dozen SASBs tied to offices that once held pristine credit grades are now quoted below 80 cents on the dollar, a common market threshold for distress.
The top-ranked slice of a $115 million bond backed by the Peachtree Center in Atlanta is quoted at around 55 cents. The debt, originally rated AAA by S&P Global Ratings when issued back in 2018, has since been cut 17 levels to CCC. In suburban Seattle, notes tied to the Bravern complex at 11155 NE 8th St. are quoted at around 80 cents. Microsoft Corp., the sole tenant, last year said it wouldn’t be renewing its 750,000 square foot lease when it expires in 2025, according to reports.
What’s more, a number of bonds have stopped paying the full interest amount owed to creditors, often the result of rental income coming in below expectations and rising debt servicing obligations.
At 600 California St., just blocks away from San Francisco’s famed Embarcadero, more than two-thirds of its space is available for rent, according to CoStar Group, a commercial-property data firm. Bondholders are owed almost $6 million in back interest. Buyers of CMBS backed by the Aspiria office campus in suburban Kansas City are owed almost $14 million.
A representative for Shorenstein, the owner of 1407 Broadway, declined to comment. Torchlight Loan Services, the special servicer appointed to intervene on behalf of bondholders, as well as investors Lord Abbett and Palmer Square didn’t respond to requests for comment.
Blackstone, which owns River North Point, said that it effectively wrote off the property in 2022 given the challenges it faces, and that less than 2% of of its owned property portfolio is in the US office sector. All other building owners either declined to comment or didn’t respond to requests seeking comment.
“The AAA rating is designed to be a debt security that would typically default less than once every 5,000 years,” said John Griffin, a chaired professor of finance at the University of Texas in Austin. “Yet, here we are not far from the financial crisis observing defaults,” he said, adding that “it does not appear that the major issues in structured finance have been fixed.”
In fact, SASBs are themselves are partly a legacy of the financial crisis.
CMBS have historically been backed by large pools of property loans. In 2009 and 2010, billions worth of deals would end up in default as the tumult in the residential mortgage space upended credit markets broadly. Banks, holding large swaths of commercial property loans on their balance sheets as they assembled the structures, were hit particularly hard.
In the years that followed, partly in an effort to expedite the process and lessen their exposure, they turned to selling more CMBS backed by a single loan financing the purchase of just one building. Investors, including mutual funds, insurers and pensions, liked them because it was seemingly easier to assess the quality of just one underlying asset, rather than hundreds.
The structure is essentially the same as a conventional CMBS. Bank lenders create an investment vehicle to hold the mortgage, and investors buy slices in the form of bonds. In exchange, they get a share of the income thrown off by the underlying loan. Cash flows follow a so-called waterfall structure, wherein the most senior bonds get paid first, while the riskiest slices get paid last.
Credit graders were quick to give AAA ratings to the most senior tranches of the deals, which typically make up around half the total structure.
Many are now saying that was a mistake.
Over a quarter of outstanding SASB bonds originally rated AAA by S&P have had their credit rating cut, compared to just 0.4% for so-called conduit CMBS that pool large numbers of mortgages, according to data from Barclays Plc. For KBRA, 17% of outstanding AAA SASBs have been downgraded, versus just 0.3% of conduits.
“Rating agencies need to revisit how they rate the AAA in these deals if they are single asset, as they don’t have the benefit of pooling,” said Leo Huang, head of commercial real estate debt at Ellington.
A spokesperson for KBRA said the company periodically reviews its methodologies and has no immediate plans to change its approach, adding that there haver been no losses so far on any SASBs the firm rated AAA. Maria Paula Moreno, Head of Americas Structured Finance at Fitch Ratings, the sole credit grader for the 1407 Broadway deal, noted that only four SASBs it rates have loans in special servicing, and that “SASB deals, in and of themselves are not the problem. The stress in the office property sector is the problem.”
A representative for S&P referred Bloomberg News to the company’s third quarter CMBS report, which stated that sharp property valuation declines and deteriorating leasing conditions led to many downgrades of office SASBs.
The most recent of them came just a few weeks ago. It was on the bond tied to the Peachtree Center in downtown Atlanta.
S&P had already cut the rating on the top-ranked slice of the Peachtree debt 11 levels over the past couple years to BB but even that was clearly not enough now.
The complex’s occupancy rate was still stuck below 50%. What’s more, the S&P analysts had come up with a new estimate on the net proceeds that the sale of the center would generate: $60 million. Back when the SASB was marketed to investors in 2018, the complex was valued at more than four times that amount.
The new rating on the debt, CCC, is just a few levels above default.
“SASB bonds are unique,” said Ed Reardon, a strategist at Deutsche Bank. “They depend on one single building. And that’s a huge challenge when the real estate becomes obsolete.”