Surge in Commercial-Property Foreclosures Suggests Bottom Is Near

Defaults and other kinds of distress have been steadily building in the commercial-property market to near historic levels because of high interest rates and the slow return of workers to office buildings. Until recently, though, many lenders have been reluctant to take over properties in hopes of a recovery and to avoid the expense and losses of foreclosure actions. 

“Lenders will do everything in their power to avoid that,” said Jade Rahmani, an analyst at Keefe, Bruyette & Woods.

But distress is working its way through the financial system after more lenders conclude that obsolete office buildings won’t recover their former value, even when interest rates decline. 

That is leading to sales of foreclosed properties and distressed mortgages. It is also bringing an increase in short sales, where lenders and borrowers work together to unload troubled property for whatever they can get.

It is possible that commercial-property values could deteriorate even further if the U.S. economy falls into recession and companies start laying off workers and want less office space. 

But in previous downturns, comparable surges in foreclosure activity has signaled the approach of a market bottom. Once lenders seize a property, they are typically quick to sell it, a process that helps determine values of properties after long periods of sluggishness in the sales market. 

Office is by far the most troubled property class. In the second quarter, the volume of office property seized in foreclosures and other actions was up about $5 billion from the second quarter of 2023, MSCI said. Apartment buildings, which have been hit hard by the increase in interest rates and the crush of new supply, had a $975 million increase during the same period.

KKR Real Estate Finance Trust recently seized a five-building Silicon Valley complex owned by a venture of Goldman Sachs and TMG Partners. The KKR unit, which held a $200 million mortgage on the property, took title at the end in June in a deed in lieu of foreclosure transaction and is expected to start marketing it soon after upgrades.

Numerous office buildings have sold at steeply discounted prices in the struggling office market in Washington, D.C. That has made it hard for lenders with outstanding loans to keep distressed loans on their books for their original values.

In the district, State Farm Life Insurance recently conducted a foreclosure sale of an office building a few blocks from the White House for $17.6 million, more than 70% below what the owner had paid in 2010.  

“Lenders are more dispassionate about values and that’s a sign of a cycle moving” toward a bottom, said Matt Pestronk, a developer who has purchased two discounted office buildings in the district for conversion to residential.

Small banks, those with assets under $10 billion in particular, have picked up the foreclosure pace. In the first quarter, the total amount of seized commercial properties they owned was up by about $125 million to $943 million, the largest quarterly increase since 2000, according to bank-data consultant Matthew Anderson.

Even if the market is approaching a bottom, pain in the commercial property industry is expected to be prolonged. Much depends on whether the Federal Reserve begins to cut interest rates, a move that many expect in the fall.

But a rate cut won’t help landlords who own obsolete office buildings that may never recover lost value. Risk in commercial property “will be with us for some time, probably for years,” said Fed Chairman Jerome Powell in Senate testimony earlier this month.

Regulators are worried about distressed commercial real estate because of its potential to ripple through the financial system. Debt maturities are expected to continue rising, with more than $2.2 trillion coming due between this year and 2027, according to data firm Trepp.

Signature Bank, which had a high exposure to commercial property, failed last year, leading to its assets being sold late last year by the Federal Deposit Insurance Corp. 

This year investors have made large cash infusions into other banks with large volumes of commercial real-estate loans, such as First Foundation and New York Community Bancorp, whose shares dropped more than 3% on Thursday after it disclosed another quarterly net loss and girded for further trouble in commercial real-estate lending.

Many creditors are also seeing a sharp increase in problem loans, which is often a precursor to foreclosures. Blackstone Mortgage Trust, which has a high exposure to office loans, last week cut its dividend and reported that it was increasing its loss reserves by 19% to over $900 million. 

This month, the delinquency rate of office loans converted into securities increased to above 8% for the first time since November 2013, according to Trepp, citing data as of last week. 

So far, foreclosures and other property seizures remain far below the level during the 2008-09 financial crisis. The total amount of foreclosed and seized properties held by lenders soared to more than $45 billion in 2013, more than double today’s amount, according to MSCI.

The level might not ever reach that height in this downturn because office-building owners have been more likely to capitulate and walk away from their properties than they were during the financial crisis. Back then, interest rates were lower, and many owners believed that their buildings would recover, so investors tried to hold on to them. 

These days owners increasingly are giving up, recognizing that demand levels for their buildings won’t return. Many are simply working with their lenders on short sales, which typically aren’t counted as foreclosures. 

Indeed, the volume of commercial-property sales that involved lender participation soared 83% in the first and second quarter of 2024 from the two previous quarters, according to Ten-X, one of the biggest auctioneers of commercial property online.

“This cycle, a lot of investors believe office values are challenged,” said Nicholas Seidenberg, managing director at the real-estate investment banking firm Eastdil Secured. “They’re saying: ‘Hey, I’m going to just walk away and not fight.’”

Gina Heeb contributed to this article.

Write to Peter Grant at peter.grant@wsj.com

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