I’ve talked quite a bit recently about the downturn in certain pockets of commercial real estate. That doesn’t just impact the landlords who own and operate affected properties but also the lenders who hold the mortgage notes.

In an average quarter, mortgage REITs (real estate investment trusts) extend approximately $10 billion in new development loans, according to the Wall Street Journal. But that activity has ground to a halt in recent months. The Mortgage Bankers Association is now estimating commercial property lending to slide to just $504 billion in 2023, a decline of nearly 40% from last year.

You can understand why they’re hesitant to write new IOUs in this environment.

Regional banks have cut back their originations as well. Blame rate tightening, which has put many borrowers in an untenable financial position. Debt servicing costs have skyrocketed, and refinancing is no longer an option in many cases.

Meanwhile, leasing fundamentals are crumbling in many locales.

The popularity of remote work arrangements has left formerly bustling office towers now half-empty. Not a good look. Lower occupancy has pressured rental rates and crimped net operating income (NOI) – a key determinant of property valuation. The end result is a growing pile of distressed debt and a wave of potential defaults.

Time To Buy?

On the flip side, if you look at the dividend yields offered by some of these names, then it’s hard not to wonder whether this is an opportune time to step in and buy. Take a look at the table below, which is just a selection of names in this space, and you’ll see what I mean…

While I can’t speak the specifics of every name in this table, I want to touch on one in particular, and then you can draw your own conclusions from there.

A Deeper Dive…

You can understand why Blackstone Mortgage (Nasdaq: BXMT) is hesitant to write new $250 million IOUs in this environment. Not that long ago, it was plowing $1.5 billion or so each quarter into new developments around the globe. Luxury resorts in Amsterdam. Warehouses in Los Angeles. Apartments in Sydney. But the company hasn’t put a penny into new loans over the past six months.

Zero.

Fortunately, Blackstone’s $23 billion portfolio has held up well thus far. The company collected $1.5 billion in loan repayments last quarter and generated distributable earnings of $0.79 per share, easily covering the $0.62 dividend distribution.

BXMT has a current yield of nearly 12%, which reflects a fair amount of market skepticism regarding its ability to meet payments. But the dividend coverage ratio has actually widened over the past 12 months from 109% to a recent 127%. The company out-earned its distribution by $30 million last quarter, with the retained surplus bolstering book value.

Nearly all of Blackstone’s loans are variable in nature, tied to a floating benchmark like the Secured Overnight Financing Rate (SOFR) – which has climbed from 0.93% a year ago to north of 5%. That means the portfolio is generating considerably more interest income these days. In fact, trailing twelve-month earnings over the past four quarters has never been higher.

But the next twelve months might not be as prosperous. Let’s be clear, Blackstone’s credit quality remains quite robust today. While 7 loans were just downgraded, 8 were upgraded. Overall, 96% of its borrowers are making timely principal and interest payments, down from 99% this time last year.

Looking Ahead

But as commercial real estate fundamentals weaken, more borrowers could face problems. Blackstone has been forced to set aside $380 million in reserves to cover potential losses, more than double the levels from a year ago. That has spooked the markets and invited quite a bit of short selling, keeping the stock in check.

Fortunately, the U.S. office space sector only accounts for about one-quarter (26%) of Blackstone’s portfolio. The rest is on solid ground.

Given stable credit quality and record cash flows, I think it would be premature to sell at this point, particularly since Blackstone has no debt liabilities maturing until 2026.

The lack of competition could ultimately prove beneficial, enabling this market leader to single out the strongest borrowers and extract better terms. Until recession fears fade, Blackstone is building a “war chest” to pounce on opportunities.

Action to Take

With all that said, rising loss reserves and sagging property collateral values pose a threat at the moment. Therefore, even though the yield on BXMT (and others like it) looks enticing, I recommend holding off until things settle down.

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