Sounds Like 2008

This is how it always starts, some problems in an obscure corner of the market, and then it explodes.

Houston, we have ignition in a dicey part of the commercial real estate market: (CRE)

Foreclosures are surging in an opaque and risky corner of commercial real-estate finance, offering one of the starkest signs yet that turmoil in the property market is worsening.

Lenders this year have issued a record number of foreclosure notices for high-risk property loans, according to a Wall Street Journal analysis. Many of these loans are similar to second mortgages and commonly known as mezzanine loans.

Mezzanine loans have high interest rates and offer a faster and easier path to foreclose than mortgages. The Journal analysis found notices for 62 mezzanine loans and other high-risk loans this year through October. That is more than double the number for all of last year, and likely the highest total ever for a single year, as higher interest rates and rising vacancies punish the property sector.

Basically, unlike a mortgage, which is secured by the property, a mezzanine loan is unsecured, though it is senior to any claims from stockholders, and so higher risk, and thus charges a higher interests rates.

They are also easier to foreclose upon.

During times of low interest rates, they are attractive because saver alternatives have low returns.

With interest rates rising, all bets are off.

………

In contrast, foreclosing on mezzanine loans is often quick and easy because they aren’t technically mortgages. Because the loans don’t appear in property records, the Journal was unable to determine the dollar value of the announced foreclosures.

These loans took off in the decade following the 2008-09 financial crisis as regulators cracked down on big banks and they became more conservative lenders. Many property owners made up the financing shortfall by borrowing from smaller banks, or by taking out these second loans from debt funds and other nonbank lenders, often on top of bank mortgages.

Lenders liked providing mezzanine debt because these loans generated higher yields, often more than 10% during years when interest rates on long-term government bonds hovered around 2%. 

………

That debt allowed investors to bid up prices while putting in little of their own money, inflating the commercial real-estate market leading up to 2022.  

………

Mezzanine loans are notoriously opaque. Unlike mortgages, they don’t appear in property records, so real-estate data companies can’t track many of them. No one knows how much of this debt is out there. 

To measure distress, The Wall Street Journal counted so-called uniform-commercial-code foreclosure-sale notices for commercial-property loans published in the print editions of dozens of national and regional newspapers going back 15 years. These notices are typically for mezzanine loans, although sometimes mortgage lenders also use them, brokers say.

Mezzanine loans are secured by the limited-liability company owning the building, not by the real estate itself. That means lenders can often take over the building in a matter of weeks, though not all announced foreclosure sales actually happen.

………

Before rates started rising last year, mezzanine loans often came with interest rates of around 10% to 12% or more, said Alex Draganiuk, who runs the commercial-loan sales desk at brokerage Mission Capital. Now these same loans often cost more than 15%. That makes it much harder to refinance when they expire, leading to more defaults and foreclosures.

This is just the start.

With the ongoing fights over return to work, with well over a million former members of the workforce either dead of disabled by long Covid, the CRE market is not coming back, and the market is largely populated by actors who have been maximizing their leverage for more than a decade.

This consequences from a downturn are likely to be extreme.  Leverage is the enemy of stability.