Warnings about the loans, bonds, and commercial-mortgage-backed securities (CMBS) tied to an incredible $11-trillion commercial property sector in the US have been talked about for months.

Defaults are rising in the commercial real-estate debt market just as borrowing costs are set to rise, raising the likelihood of a slowdown of the $11 trillion U.S. commercial property market in 2017. Analysts predict that some commercial real estate borrowing is going to be more expensive and complicated due to the increase in regulation to take effect at the end of the month. Concurrently, interest rates have increased since the election and seem to be on track to stay that way from recent historic lows.

Runaway inflation and huge interest rates are what’s possible for 2017. The worries raise new and very real concerns for the commercial property market as it enters its eighth year of expansion.

The Affects of Rising Default Rates

To many lenders’ dismay, defaults are on the rise. More than 5.6% of some $390 billion worth of commercial property mortgages that have been packaged into securities was more than 60 days late in payment in September. That was up from a 4.6% delinquency rate earlier this year.

Regulators earlier this year warned that vacancy has been growing in the rental apartment market and now we are already seeing landlords fighting a slowdown in sales and the rising vacancy rates of multifamily housing complexes across the U.S., and of office space in big commercial markets like Houston and Washington, D.C. Commercial property sales as a whole were down 8.6% in the first nine months of 2016 to $345.4 billion.

So what’s to blame for the increase in defaults? Part of the problem in the current cycle of CMBS that were originated before the Financial Crisis in 2006 and 2007 and are now coming due. 10-year loans issued in those years are now becoming due, and many borrowers aren’t able to pay them off despite rising property values causing a lot of stress in the already squeezed market.
Analysts predict borrowers won’t be able to pay off roughly 40% of the commercial mortgage-backed securities (CMBS) loans coming due next year, with suburban office properties being hit particularly hard.

What’s Going on with Bonds?

Bonds have sold off beyond the US because investors believe the Federal Reserve will raise interest rates more aggressively than expected, which would then affect other central banks. While the sell-off has been the greatest in the U.S., government bonds prices are down across the world. Eventually that could impact commercial property.

The Affects of Dodd-Frank

A financial crisis-era regulation is about to take effect which would further constrict an industry built on borrowed money. The Dodd-Frank rule that will take effect on December 24 requires issuers of mortgage-backed securities to retain at least 5% of the securities they create. By having their skin in the game, they dampen the type of risk-taking and exploitation common before the financial crisis of 2008.

The risk-retention rules will likely make borrowing more costly and complicated, raising the chances that some property owners won’t be able to refinance loans or repackage them into commercial mortgage-backed securities (CMBS). More likely than not, banks, insurance companies, and other market participants (hedge funds, PE firms, etc.) will refinance many of these loans instead. If banks refinance them, it will further increase their exposure to CRE, which would likely be a credit negative.

Although concerns have been addressed — there have been comments made by President-elect Donald Trump of repealing Dodd-Frank — chances are good that many of the provisions will stay on the books, including the risk retention rule.

The Perfect Storm

All these things will come together after the bubble has been inflated to the max, with new rules in place, at a time of possibly high rising interest rates. To top it off, there seems to be other problems flaring up as well. Vacancy rates have been growing in the rental apartment market and those higher interest rates in the next two years could damp price growth there, making for another perfect storm in a post-bubble commercial real estate. Hopefully, safe guards in place will prevent the $11 trillion bubble from popping.