By Amber Sefert

Managing Director, Credit & Asset Management

Crafting the right solution for a maturing office loan within a collateralized loan obligation (CLO) is much like collecting all the unique ingredients to mix a perfect cocktail. Every detail needs to be reviewed and analyzed before determining next steps. Commercial real estate (CRE) is undergoing a generational transformation in how office space is used, designed, and located. Current economic factors are playing heavily into a borrower’s options at loan maturity. For a borrower with a maturing loan, they have to navigate through: interest rates that are likely to remain higher for longer (with a nice reprieve of a 50bps cut in September), insurance costs that have increased, office vacancies that continue to waiver, lower valuations, and lenders having little to no appetite for originating office debt. Borrowers with maturing loans can find themselves in a pickle – but not the garnish kind.

Office values in U.S. central business districts (CBDs) plummeted 48.9% from peak to trough, according to MSCI data, while more than USD 210 billion worth of loans are set to mature this year, according to the Mortgage Bankers Association (MBA). However, the majority of these loans are unlikely to lead to forced sales at maturity. Lenders and servicers for commercial mortgage-backed securities (CMBS) and CLO transactions continue to negotiate extensions with borrowers who remain financially supportive of loans in the hope of a sale or refinance in improved market conditions within 12 to 24 months. Whether extensions are the right approach remains to be seen, but the probabilities favor extension over foreclosures or forced sales in some cases.

CMBS vs. CLO:

CMBS and CLOs share some similarities, but also many differences.

CMBS

Most U.S. CMBS transactions involve loans at the longer end of the five-to-10-year range and are typically secured by stabilized assets. Amortization (if included) typically ranges between 25 to 30 years. The originating lender sells most of the debt but retains a strip to maintain economic alignment with noteholders, as required by regulations. The B-Piece buyer purchases the first-loss position. Most loans are sized with a maximum loan-to-value (LTV) of 75% and a target debt service coverage ratio (DSCR) of 1.25 to 1.35x. If CMBS were a cocktail, it would be an Old Fashioned – classic, reliable, and balanced. An old-school favorite that keeps counterparty interests aligned—neither too bitter nor too sweet.

CLO

By comparison, U.S. CLO transactions typically securitize shorter-term bridge loans (usually three years, with two one-year options) tied to a transitional business plan. Additional debt is often linked to the successful execution of that plan over the course of the loan. CLO issuers regularly purchase higher up the bond stack to mitigate the risk of losing control over the first-loss position and approval rights as the collateral manager. Bridge lenders using CLOs tend to maintain stronger relationships with borrowers, closely monitoring asset stabilization progress. Since sponsors are executing transitional business plans, LTVs and debt-service coverage ratios (DSCRs) are less stable. A portion of the debt is often held outside the CLO, ringfenced for future funding requirements or reserves for shortfalls.

If CMBS is an Old Fashioned, then a CLO would be akin to a Negroni – bold, complex, and layered. CLOs mix shorter-term loans with greater risk but potentially higher returns, making these securitizations more adventurous and dynamic compared to the steady, reliable CMBS.

The Macro Mixer: Shaken, Not Stirred

Securitizations saw a robust pickup in issuance volume following the 2020 pandemic-related downturn. In 2021, domestic issuance spiked for CMBS (up 95% to USD 109.12 billion) and CLOs (up fourfold to USD 45.44 billion), relative to the pandemic-interrupted prior year, according to Trepp data. However, issuance slowed markedly in 2022 as office-related securitizations absorbed stress from rising interest rates, inflation, and the risk of office obsolescence.

Among CLO 2.0 transactions, only a modest number of tranches across the 13-year vintage have defaulted. Significant credit deterioration across CLOs and CMBS has triggered a rise in downgrades and special servicing transfers. This reflects broader market stress (i.e., macro headwinds, tenant demand, low debt liquidity, and obsolescence risk) which significantly impacts shorter-term, higher-risk loans. Delinquency rates have risen as sponsors struggle to refinance maturing loans at significantly higher rates and under tighter lending standards. S&P Global considers eight tranches from eight CLO 2.0 transactions as future default candidates.

In the CMBS universe, annual office default volume surged 55.9% to USD 4.8 billion in 2023 (2022: USD 1.6 billion), with the majority at loan maturity, according to Fitch Ratings. In the same year, single-borrower downgrades also spiked. At the all-sector level, 463 tranches were downgraded, up 128% from the prior year, with the office sector accounting for the brunt of the hits. In the first eight months of 2024, 653 tranches were downgraded, with office properties accounting for 73% of those actions. In August, the rate of securitized office loans transferred into special servicing jumped to 11.91%, the highest level in 11 years, according to Trepp. In Q3 2024, around USD 5.1 billion in office loans will mature, followed by USD 4 billion in Q4 and another USD 10 billion in H1 2025, according to DBRS Morningstar data.

The Fed’s Mojito Moment

The picture described may finally start to improve, as the era of historically high borrowing costs is finally easing. In September, the Federal Reserve cut interest rates by 50 basis points—the first reduction since March 2020—after raising rates to multi-decade highs to combat post-pandemic inflation. This marks the start of an easing cycle.

The Fed’s forward guidance suggests another 50 bps cut before the year’s end, followed by 100 bps in 2025, and 50 bps in 2026. Though the effects of these rate cuts will take time to materialize, the Fed is clearly on a path to normalize rates, aiming for a neutral rate of around 3.5%, still much higher than the ultra-low levels between the post-GFC period and the onset of the pandemic. This guidance significantly reduces uncertainty over future interest rates. Lower borrowing costs are expected to narrow the refinancing gap for maturing loans and the bid-ask spread on property transactions, which has sidelined nearly USD 400 billion in equity capital, according to Preqin. For the remainder of 2024 and into 2025, transactional activity may pick up again as opportunistic buyers re-enter the market.

After nearly three years of high interest rates, the shift in monetary policy toward more accommodative financial conditions will help reset market dynamics over the next 18 months. This transition is expected to provide much-needed relief to struggling office loans. In keeping with our cocktail analogy, this is the Fed’s Mojito moment – a light, refreshing tonic after a prolonged period of stringent rate hikes.

Extension Strategies: A Measured Approach

As part of our overall workout strategies, extensions have become a key tool for managing maturing loans. While foreclosure, deed-in-lieu (DIL), receiver sales, or note sales can sometimes be better options, extensions are a possible resolution when borrowers remain committed and willing/able to financially invest in maintaining ownership.

For office-related loans, extensions have proven particularly useful, especially as asset-level challenges are driven more by broader economic factors – such as higher interest rates, rising insurance costs, and property taxes – as well as cultural shifts like hybrid working, rather than purely by borrower underperformance.

Each extension requires a case-by-case evaluation of debt metrics, borrower performance, historical equity contributions, and reserves for future capital needs. Extensions allow time for borrowers to continue stabilization efforts, reduce principal balances through paydowns or amortization, and secure refinancing in more favorable market conditions over the next 12 to 24 months. Improving office demand could also benefit sponsors as companies begin to scale back on remote work and tighten hybrid working policies.

In mid-September, Amazon announced that corporate employees must return to the office five days a week starting in January, marking the first major tech firm to fully reverse hybrid working. Since 2023, companies including Apple, Meta, Zoom, and Dell have all reduced remote work flexibility, while financial firms have enforced stricter in-office attendance. According to a September 2024 survey by WFH Research, around four in ten U.S. employees still work in a hybrid model. Looking ahead, a slowing economy and softening labor market may shift power back to employers. This could prompt stricter in-office policies, spurring office demand and reducing vacancies.

Meanwhile, some banks have begun selling distressed office loans to free up balance sheets and re-enter the market as confidence gradually returns. Office and construction loan sales have picked up since late 2023, as banks seek to proactively resolve problem loans and reduce their exposure to the sector, according to S&P Global. Banks continue to market deals quietly.

Similar to crafting a cocktail, executing a successful loan extension requires balance, precision, and the right ingredients to achieve a solution that satisfies all parties. With the right mix, loan extensions can provide the refreshment the market needs to weather this challenging time—a perfect drink to cap off a tough period.

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Amber Sefert, Managing Director, Credit & Asset Management at Trimont, has over seventeen years of experience in commercial real estate finance and oversees a team managing both performing and non-performing debt assets.

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