The (Possible) Commercial-Mortgage Meltdown

Card-carrying pessimists—partisans of the Eeyore Caucus, of which I am a proud member—have been waiting on the commercial-mortgage version of the 2007-08 subprime meltdown for 15 years. That’s a long time to wait for anything, but pessimists are not often disappointed – despair springs eternal. 

Here is the issue in brief: This is a terrible time to own office space in most of the country, and a worse time to own it with a big mortgage. Vacancy rates are sky-high, with nearly one-third of commercial space currently unoccupied in once-booming San Francisco, 20 percent empty in Manhattan, etc. There are many reasons for that: organic economic changes, the COVID-driven rise in remote work, the increased crime rates in progressive-run cities around the country, and more. The fight against inflation has required higher interest rates, which is bad news for the holders of the commercial mortgages that are going to have to be refinanced this year—and that includes about one in four of all such mortgages. Move the horizon out to two years from now and you’re talking about more than half of those mortgages. That means that most owners of office buildings are going to see higher mortgage payments at the same time they are suffering lower incomes. 

The total amount of outstanding mortgage debt on office buildings at the moment adds up to a little more than $3 trillion—if there are a lot of defaults on those loans, a lot of banks and financial institutions are going to have some gaping wounds in their balance sheets. And, don’t look now, but: Delinquencies are up sharply. 

Banks do their accounting in roughly the opposite way their customers do. For you, an outstanding debt is a liability and money in the bank is an asset, but, for a bank, deposits are liabilities and outstanding loans are assets. As with residential mortgages, commercial mortgages end up being “securitized,” meaning sliced and diced and reorganized to create tradable financial instruments. In the 2007-08 mortgage meltdown, securities and investment portfolios were constructed in such a way that everybody would be fine if the default rate never got above a certain point; when the default rate got well above that point, a whole lot of assets that had appeared to be solid gold turned out to be approximately 100 percent iron pyrite.