This year could be the breaking point for commercial real estate distress, research firm says

• Commercial real estate will finally face its reckoning in 2024, Capital Economics warned.
• That's because many property owners are choosing to "extend and pretend" their debts are fine, the firm said.
• But there's $2.2 trillion of CRE debt coming due by 2027, which could bring a wave of distress.

This year will be when the distress brewing in commercial real estate finally reaches its breaking point, according to Capital Economics.

The research firm pointed to pessimism that has clouded the commercial real estate sector for the past year. Commentators have been warning of a crash, thanks to tightening credit conditions as a wave of debt from property owners comes due. 

Around $541 billion of commercial real estate debt officially matured in 2023, though fallout was muted as many loans were granted extensions, the firm said.

That's a sign many building owners are looking to "extend and pretend," but that strategy can't last forever as there's still a $2.2 trillion mountain of commercial real estate debt that will mature by 2027, according to Capital Economics deputy chief property economist Kiran Raichura. 

Higher interest rates and tighter financial conditions have discouraged lenders from financing risky commercial real estate loans, or have made lenders only willing to do so at higher borrowing costs.

Some borrowers could see their interest costs double after they refinance their matured loans, Capital Economics estimated, potentially sparking a wave of defaults or delinquencies. 

"We expect evidence of distress to ramp up this year as loan extensions end. Many borrowers will be forced to either inject new capital, return assets to lenders, or sell into a soft market. Those assets returned to lenders will also ultimately end up on the market, helping bring greater pricing clarity and more substantial valuation markdowns," Raichura said in a note on Monday.

Some commentators have dismissed the likelihood of such outcomes, pointing to expectations for the Fed to cut interest rates later this year. Meanwhile, property investors like Brookfield are raising cash to potentially buy cheap commercial real estate properties that hit the market.

But Fed rate cuts could easily disappoint investors, and firms aren't raising nearly enough money to buy the total amount of commercial real estate debt that's approaching maturity, Raichura said. In December, private equity firms had $250 billion earmarked for real estate — just 11% of the total amount of maturing debt in the sector. 

"Putting this all together, we expect an increase in distress this year as borrowers and their lenders are unable to continue kicking the can down the road," Raichura said. 

Defaults and late payments on commercial real estate debts are already on the rise, and property values have begun to fall. The sector is now in the midst of the greatest price slump in the last half-century, according to the International Monetary Fund, with values diving around 11% last year.

Raichura expects that distress to worsen this year. Prices will fall another 10% in 2024, he estimated, making for a 20% peak-to-trough decline. 

Some commentators have warned of an even more severe crash coming for commercial real estate. One NBER paper estimated that total losses in the CRE space could pile up to $160 billion.

Veteran investor Kyle Bass warned that the collapse in office building prices alone could cost $250 billion, thanks to commercial real estate troubles as well as plunging demand for office buildings.