The Last Domino Before Recession

Last week, I wrote about how President Trump’s tariff and deportation policies are putting a chill on the U.S. housing sector. The “American Dream” has become less possible as “homeownership is out of reach for most people.”

Even so, as I explained, “I don’t see any signs of a housing crisis unfolding anytime soon. We’re simply dealing with a unique set of circumstances that have the market more… undecided… than usual.”

In which case, you can breathe a sigh of relief. We’re not in for a repeat of 2008 despite all the issues we’re seeing.

As for the commercial side of real estate – particularly the commercial mortgage-backed securities (“CMBS”) space? Well, there are some serious debt issues we need to discuss.

As with housing, they’re not catastrophic. But they could be the domino that takes the economy down into recession.

I’ve been beating that drum for a while now, I know, as have other team members here, including Nick Ward. We both agreed on last Thursday’s Wide Moat Show that the stars are lined up for a slowdown.

Trepp, the leading commercial real estate (“CRE”) data provider, recently announced that the rate of all CMBS loans in special servicing – where a third-party entity buys out defaulted or risky loans – rose from 7.14% in February 2024 to 10.32% last month. It also reported that $79.7 million across seven loans were resolved in February, amounting to $38.2 million in total losses.

The average loss severity was 47.87%.

That’s bad, though it was nothing compared to January’s losses of $246.9 million. And we’ll probably see more of that this year.

Even so, I believe that 2025 offers significant room for opportunity in the world of CMBS – too much so to ignore.

The CMBS World May Have Already Seen the Worse

Truth be told, commercial real estate has been in crisis mode for quite a while – perhaps as far back as 2008. But the 2020 shutdowns definitely brought it all into sharp focus.

It goes without saying that entire office buildings, shopping sites, and other CRE facilities shutting down for months on end would have a negative effect. And as people fled from big cities, apartment complexes suffered lower rental revenue as well.

That has resulted in waves of CRE loans coming due for landlords with severely reduced income and savings.

According to the Mortgage Bankers Association, 20% of the $4.8 trillion, or $957 billion, of outstanding commercial mortgages held by lenders and investors will mature this year. That includes 22% of industrial properties in the U.S., 24% of office properties, and 35% of hotels.

Now, I’ve mentioned the housing market crash twice here. So let me be clear: We’re not looking at an apples-to-apples comparison. Most of the loan-to-value figures we’re looking at today are significantly lower than they were 17 years ago: over 60% or higher back then and less than 45% today.

This helps mitigate the risk of declining property value. And the Federal Reserve should cut rates in May, further reducing the pressure.

Moreover, based on Wide Moat Research’s analysis, it appears that 2024 was as bad as it’s going to get. There’s now less supply and greater demand in sectors such as apartments, logistics, and retail.

That’s why we’re viewing CRE debt as increasingly attractive… especially when it’s held by commercial mortgage real estate investment trusts, or mREITs.

To quote REIT representative Nareit, mREITs “provide financing for income-producing real estate by purchasing or originating mortgages and mortgage-backed securities.” They then profit from the resulting interest payments.

Some mREITs focus on residential mortgages, but they don’t tend to offer investors as much value as their commercial cousins. And I don’t expect that to change anytime soon considering the housing market situation.

But commercial mREITs look set to outperform soon enough thanks to their ability to source new loans with looser lending requirements from traditional banks. And there are two of them that stand out especially to me right now.

Two Potential Picks From the mREIT World

Starwood Property Trust (STWD) is one of my favorite mREITs all around. It has never cut its dividend once, making it the one and only exception among commercial mREITs.

That’s partially because of its diverse real estate and infrastructure platform. Its $25.3 billion in assets is comprised of:

• Loans (54%)

• Owned properties (13%)

• Residential lending (11%)

• Infrastructure lending (10%)

• Other investments (12%)

Importantly, U.S. office loans represent only 10% of that total – another reason why its balance sheet remains so strong. In the fourth quarter of 2024, STWD executed $2.3 billion in debt transactions with no debt maturities until July 2026.

Liquidity stands at $1.8 billion with an adjusted debt-to-undepreciated-equity ratio of just 2.1 times. That’s its lowest level in over four years.

Last week, Starwood announced the private offering of $400 million of unsecured senior notes due 2030 (a 5.5-year term); the deal was eventually upsized by 25% to $500 million.

STWD’s dividend yield is an elevated 9.7%. But it’s easily covered by the mREIT’s earnings per share as evidenced by its 88% payout ratio.

Source: Wide Moat Research

Shares have returned 7.3% year to date, and I expect them to climb further still.

Then there’s Ladder Capital (LADR), a smaller player that owns $1.6 billion in loans, $1.1 billion in CRE securities, and $904 million in actual real estate. Its loan portfolio specifically is comprised of middle-market customers with an average loan size of $25 million to $30 million.

This mREIT is swimming in cash right now, ending 2024 with $2.2 billion in liquidity. That includes $1.3 billion in cash, representing 27% of its total assets. And management anticipates a significant increase in loan originations this year, with the pipeline already exceeding $250 million.

Shares are attractively priced right now with an 8% yield and a well-covered dividend.

Source: Wide Moat Research

A Word of Caution About Investing in mREITs

Now, before you run out and buy either or both, understand that mREITs in general do have a more volatile track record than “regular” REITs that simply rent out property. That’s why I don’t tend to recommend them to retirees.

If you’re living on a fixed income, you might want to consider holding only the most stable shares. In general, if you can’t handle volatility, I would stay away from such assets – especially if I’m right about commercial real estate leading the way into a garden-style recession.

However, if you’ve got some wiggle room for assets that offer greater risk but greater reward in return…

Mortgage REITs like Starwood and Ladder could be precisely what you’re looking for.

Source: Wide Moat Research

Regards,

Brad Thomas
Editor, Wide Moat Daily

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