Sleepy Delinquencies Belie Potential Peril
And an important distinction between residential and commercial loans
Existing homeowners and owners of commercial properties including rental properties are in historically good shape at the moment (other than on traditional commercial office space, which is a separate story altogether). The delinquency rate on single-family homes is just 1.70%, which is near historical lows. On top of that, nearly 40% of homeowners in the United States now own their homes outright. If you combine the low delinquency rate of 1.70% with the fact that 40% of homeowner don’t even have mortgages to begin with, the state of the American homeowner is extremely strong and is worthy of celebration and appreciation at this moment in time.
Yet one unintended consequence of such a low delinquency rate is that it helps to keep the market essentially frozen. The home market needs turnover, and right now there is not much of it. A major reason why is due to the interest rate lock in effect (i.e. people are not moving because they do not want to give up their pre-2023 interest rates). But a second reason why people are not selling their homes is that they don’t have to; most homeowners are not in peril.
Compare the present rate of 1.70% with peak delinquencies following the Great Recession. For three straight years from the end of 2009 until the end of 2012, delinquency rates on home loans were between 10-12%. This generated a lot of sales from people who simply needed to get out (although this was tempered by the fact that the economy was in such poor shape that there also weren’t many eager or well-qualified buyers). Delinquencies then began a pretty steady decline for much of the next decade before settling out at their current low levels.
For most of the 1990s and 2000s, delinquencies were generally between 2.0-3.0%. That might not seem like a big leap over today’s rate of 1.70%, but it represents tens of thousands of homes that might otherwise end up hitting the market through a forced sale.
Let me offer a quick and sincere aside that in an ideal world, everyone would be able to afford and stay in their homes forever. It would be nice if the “home ecosystem” did not involve people being forced to sell when they find themselves in financial peril. And the best way to generate new housing inventory would be to build more homes, not to have existing homeowners find themselves in financial peril and be forced to sell.
Yet, as mentioned above, the ecosystem needs turnover. And it is almost certain that delinquency rates will be higher at the end of 2024 than they are today, and higher still as we progress through 2025. Why? For starters, a lot of people have bought more expensive homes in the past two years and have done so with higher interest rates. The math on that is challenging. Unfortunately the most likely loans to go bad (and the homes most likely to be sold) are the ones that have been bought more recently under these less favorable mathematical conditions. This would be especially true if we experience a meaningful economic downturn that could lead to job losses. I won’t dwell on this too much as it feels callous to talk about people being forced to sell their homes if they find themselves out of jobs, but high home prices + high interest rates + economic peril is a disastrous formula.
I do have some confidence, however, that we are not facing any sort of housing market crash on the residential side of things. This is in large part due to the statistics I mentioned at the outset: not only do 40% of Americans own their homes outright, but also of the overall national home mortgage portfolio, many homeowners have residential loans at extremely low rates, and are therefore more likely to be able to keep up with their payments. I wrote three years ago about how 2021 was not 2007; I also don’t believe that 2024 is 2007, at least on the residential side of things.
The Difference (and Heightened Risk) of Commercial
Risks are far greater right now on the commercial lending side of things. This is despite the fact that current delinquencies on commercial real estate loans are even lower than delinquency rates on home loans. Whereas the delinquency rate on home loans as noted above is 1.70%, the delinquency rate on commercial loans secured by real estate is just 1.18%!
The commercial side of things has one key variable at play, though, that makes it different from residential lending, and it should give pause to commercial borrowers. The difference is this: whereas a residential loan is typically fixed for the life of the loan (i.e. 15 or 30 years), most banks only offer fixed rates on commercial loans for the first 3, 5, 7, or occasionally 10 years of the term. The most common fixed-rate period is 5 years. The overall term of a commercial loan may be as long as 20 or 25-years for a loan secured by commercial real estate (including rental properties), but the interest rate is typically only fixed for the first five years. In fact, of the commercial loans I have done as a lender, I would estimate that at least 85% of them have been fixed for the first five years of the term only.
What happens after the fixed period ends? Typically after five years, the interest rate either re-fixes at whatever the new market fixed rate is at that time, or it becomes variable at a margin above Prime Rate (typically 100 basis points or 1 percentage point above Prime Rate). The problem for a lot of commercial borrowers is that they may have originally borrowed in an environment where banks were offering fixed rates of, say, 4.25-4.75% for the first five years of the term. These loans were ubiquitous from March 2020, which was the moment that the Fed ratcheted interest rates down, to May 2022, which was when rates began to climb. Looking ahead to March 2025, however, those five-year fixed rate periods will start to end.
Without a notable drop in interest rates between now and then, many borrowers will see their interest rates go from that fixed rate of, say, 4.50%, to a variable rate of 9.00% or more as Prime Rate is currently sitting at 8.50%. That is a lot of additional interest expense and will present significant challenges to the cash flow of many businesses and commercial property owners. In fairness to banks, no one expected interest rates to rise as much as they did, and not even the banks themselves really want to see rates this much higher than they were five years ago. But waves of these loan re-pricings are coming starting next year.
What borrowers in this situation urgently need is a meaningful drop in interest rates before their five-year fixed rate periods end. The end of a five-year fixed rate period and subsequent conversion to Prime Rate + 1.00% would be more manageable if Prime Rate were, say, 5.50% instead of the 8.50% that it is today. To be sure, it is not likely that Prime Rate will be down to 5.50% by this time next year, but it is likely to be down a bit from where it is today. But realistically we are only talking about a decline from the current 8.50% to maybe 7.50% by this time next year, so commercial borrowers need to be mindful of big changes to their cash flow once their five-year fixed periods end and their interest rates go up.
What Does it Mean for the Commercial Real Estate Market?
I have no doubt there will be a notable uptick in sales of commercial properties starting next spring and for the subsequent 2-3 years as these waves of loans that were originated in March 2020 to May 2022 come through their five-year fixed rate periods and re-price. For many property owners, it will just be a question of math: their cash flow might work at a 4.50% interest rate, but it might not once the interest rate goes to 9.00% or more. Many commercial property owners will decide to sell (or will have to sell).
My advice to existing property owners is to be aware of how your cash flow will change with significantly higher loan payments due to the higher interest costs once a loan goes from fixed to variable. If you are fortunate enough to have meaningful cash reserves, deploying them at the time of conversion to pay down debt would not be a bad idea.
For real estate investors who have been patiently waiting on the sideline, keeping your powder dry is likely to continue to prove to be a good strategy in the year ahead as there are sure to be more and better opportunities in 2025 and beyond from those who are forced to sell. Hunkering down and waiting for better opportunities to come is not a bad strategy right now at all.
Ben Sprague lives and works in Bangor, Maine as a Senior V.P./Commercial Lending Officer for Damariscotta-based First National Bank. He previously worked as an investment advisor and graduated from Harvard University in 2006. Ben can be reached at ben.sprague@thefirst.com or bsprague1@gmail.com.
I didn’t get a chance to put together a Weekly Round-Up this week because I have been busy with work responsibilities and family. I’ll see you next week for another article. Have a great week, everybody!