There are striking similarities between what happened during the housing collapse of 2008 and what is currently happening in commercial real estate.
Adjustable-rate mortgages (ARMs) became prevalent during the runup prior to the Great Financial Crisis (GFC). The Federal Funds Rate was 1.25% on June 30, 2004, and they hiked for 2 years until June 29, 2006, up to 5.25% before pausing.
After Covid floating rate loans became popular for commercial real estate. March 17, 2022, the Federal Funds Rate was 0.25% and they hiked up to 5.30% on July 26,2023 before pausing.
Federal Funds Rate History 1990 to 2023
2008 Financial Crisis
Interest-only, floating rate loans increased from 7 percent of the mortgage market to 29 percent from 2004 to 2006 according to a 2010 report to Congress on the Root Causes of the Foreclosure Crisis.
Many borrowers did not understand how the ARMs worked but only saw a lower payment, not realizing the payment adjusts higher after the initial teaser rate expires.
This caused the foreclosure crisis as many were not able to afford the higher adjusted payment.
Collateralized Debt Obligations (CDOs) are financial instruments that bundle individual loans into securities which are then sold in the secondary market.
In 2006 and 2007 almost $400 Billion worth of CDOs were issued according to ProPublica.
The majority holders of these securities were insurance companies, banks, pension funds, and hedge funds.
Once the individual borrower could no longer make payments on the interest-only, floating rate loans or ARMs, it caused a ripple effect in the CDO market.
The losses were heavy, and the Great Financial Crisis of 2008 was the result.
2021 CLO Activity Skyrockets in the US
A Collateralized Loan Obligation (CLO) is a single security backed by a pool of debt. With a CLO, the investor receives scheduled debt payments from the underlying loans, assuming most of the risk if borrowers’ default.
The US CLO market enjoyed a banner year in 2021 after Federal Reserve stimulus which carried into 2022.
The CLO investors were getting 4% to 5% on their money when the Federal Funds Rate was effectively zero.
Commercial Real Estate (CRE) loans are usually fixed-rate; however, as competition for assets heated up lenders went further out on the risk curve.
Many commercial real estate loans issued post-Covid were interest-only, floating rate much like before 2008 in residential.
The loans barely covered the interest payments and many borrowers had to escrow for interest reserves while the property’s income caught up.
What followed that CLO boom was an unprecedented rate hike, expense inflation, rising insurance costs, and a plummet in demand for office.
According to the Mortgage Bankers Association almost half of all commercial property debt is floating rate.
With rents flattening out nationwide and fears of recession around the corner, the defaults are starting to pile up.
The current CLO market is approximately $1.2 Trillion or 3 times as large as the CDO market in 2008.
Conclusion
Only time will tell if this is going to be another 2008. The timelines match up closely though. A rise in interest-only, floating rate loans right before a runup in rates.
Once the housing bubble started to burst and unemployment started to rise, the Fed started cutting in 2007. Then the system started to unravel.
So far, the Fed has been able to keep rates at current levels since July 2023. The stock market is up, and unemployment is low so there is no need for immediate action.
Many commercial properties are in trouble now despite those factors so any sign of economic downturn could spell more trouble for commercial real estate.
This article is in no way financial advice, I just find the subject interesting and see the parallels of what happened in the past.
