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Challenges in Commercial Real Estate Lending

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4.7

Andrew R. Michaud

• February 23, 2024

The latest year-end reports from a group of lenders paint a challenging picture for certain segments of commercial real estate.

Struggles for Mortgage Real Estate Investment Trusts

During the December quarter, mortgage real estate investment trusts (mREITs) like Starwood Property Trust and Blackstone Mortgage Trust faced difficulties. Earnings calls among these smaller-cap lenders highlighted issues such as loss reserves, downgrades, and foreclosures on office buildings and apartments.

While many faced challenges, the majority managed to maintain sufficient cash flows to cover dividends. Sector leader Starwood saw a 2.5% increase in shares after reporting stronger-than-expected year-end results. Similarly, Arbor Realty Trust surprised with better interest income figures in its recent report.

Market Sensitivity to Interest Rates

The performance of mortgage REIT stocks often reflects concerns about interest rate fluctuations. These stocks saw success during the era of low interest rates but encountered obstacles as vacancies and borrowing costs rose. Despite a 30% increase at the end of 2023, mREITs have faced uncertainties related to potential Federal Reserve rate cuts.

Currently trading around 83% of book value with an average yield of 11%, mREITs present an opportunity for investors, according to analyst Sarah Barcomb from BTIG. Barcomb recommends buying shares of Starwood and Blackstone mREITs, noting their potential for growth if market conditions prompt a Fed pivot later in the year.

Concerns Surrounding mREITs and Floating-Rate Loans

One of the main concerns regarding mortgage Real Estate Investment Trusts (mREITs) revolves around the floating-rate loans obtained by borrowers during a period of low interest rates. To mitigate risks, REITs often require borrowers to acquire derivatives or guarantees that effectively limit the impact of potential rate increases on these loans. However, as some loan vintages mature this year, certain REITs may face the challenge of replacing rate caps at a cost that could be burdensome for financially strained borrowers.

Market Response and Investor Speculation

The looming threat of rate resets has prompted some investors to adopt a bearish stance on mREITs like Blackstone Mortgage, anticipating a reduction in dividends from these lenders. Contrary to these expectations, Blackstone's February 14 report on the December quarter revealed that its cash "distributable" earnings of 69 cents per share surpassed its dividend payout by 111%. Moreover, the majority of borrowers managed to successfully renew their expiring rate caps, providing reassurance to investors.

Mixed Performance Among mREITs

While Blackstone Mortgage demonstrated resilience in maintaining dividend payments, other players in the mREIT space faced challenges. A recent December earnings report from Ares Commercial Real Estate indicated a decline in distributable earnings to 20 cents per share from 25 cents in the previous quarter. Consequently, Ares opted to reduce its quarterly dividend by 25% to 25 cents per share, leading to a 6.6% drop in its stock price to $7.65 following the announcement.

Future Growth Prospects and Strategic Outlook

Despite the decline in share value, executives at Ares Commercial Real Estate expressed confidence in the company's ability to seize lucrative lending opportunities while addressing existing portfolio issues. With many traditional banks adopting a cautious approach to lending, there remains untapped potential for expansion in the lending market, positioning mREITs like Ares for future growth.