Bulletproof to Bust: Top AAA Bonds Tarnished by a Blackstone Office Deal’s Blow Up

Investors in a Blackstone-financed property recently took roughly a 26% loss on AAA bonds, the first of this cycle

Top AAA-rated commercial property bonds have been tarnished by a defaulted office loan on a Blackstone Inc. building in New York City, which in May left investors with big losses.

While Blackstone BX, -0.14% ran into trouble on 1740 Broadway, a 26-story office building near Manhattan’s Columbus Circle, in the wake of the pandemic, it took several years to resolve its huge mortgage bill.

It wasn’t until recently that investors in the property deal received some of their money back after more than two years, albeit after taking a $190 million collective hit on their roughly $300 million investment, according to data from CrediQ.

The loss was so steep it wiped out several layers of bonds, including part of the top $157 million AAA class of bonds. Those AAA bonds lost $40 million, the first failure of its kind in this cycle.

AAAs are designed by Wall Street to be the cream of the crop, structured to withstand the worst of the worst, while still paying investors back in full, without ever taking a write off.

“It’s big,” said Dave Goodson, head of securitized products at Voya Investment Management, of the aftershocks of the loss. What was an “unimaginable scenario” has now turned into a grim point of reference for how bad losses can get, he said.

The reckoning, while slow to unfold, has the industry on edge about other potential pitfalls in top-rated commercial mortgage bonds tucked away in portfolios.

A chief concern is that AAAs pitched as almost bulletproof even in a downturn could wind up blowing a big hole in investment portfolios, despite an economy that is still chugging along.

“You at least have to speak to it,” Goodson said of the roughly 26% loss on Blackstone’s AAA debt, adding that the conversation has shifted to “how badly do I need to stress this to see if the bonds hold up.”

AAA rated commercial mortgage bonds have long been considered safe investments for “widows and orphans,” the type of assets typically favored by insurance companies and pension funds. That’s because they offer a little bit of income, but limited credit risks, while also helping fund long-term client obligations.

In the case of Blackstone’s 1740 Broadway, bankers spun the property’s roughly $300 million senior mortgage into six classes of bonds. The top AAA class was protected by five junior classes of bonds, designed to absorb losses first, if the borrower defaulted. In theory, there should have been enough cushion in the deal’s junior classes to prevent a AAA loss, even if the loan repaid at a big discount.

That isn’t, however, how Blackstone’s bonds shook out.

“We wrote this property off nearly three years ago,” a Blackstone spokesperson said, in a statement to MarketWatch. “Less than 2% of our owned portfolio is traditional U.S. office. This is not a new development and is a rare instance in our nearly $600 billion portfolio.”

Blackstone, one of the world’s biggest landlords, has been one of the commercial mortgage bond market’s most prolific borrowers in recent years. Bankers distributing their bonds frequently pointed to the strong sponsorship of the borrower as a selling point.

While the real-estate giant has defaulted on some properties, other funds within the firm have been capitalizing on the distress of others by snapping up buildings and property debt at steep discounts.

See: Blackstone executive says commercial real estate is bottoming

Slashed building values

Blackstone, like many landlords, financed 1740 Broadway in New York in a now bygone era of low interest rates, abundant credit and sky-high valuations. It received a sub 4% fixed-rate mortgage for 10 years, which required only interest, but not principal, to be paid during the life of the loan.

Then came the pandemic, hybrid work and the Federal Reserve’s most aggressive rate hikes in four decades. By November 2023, the building was mostly empty, and its initial $605 million appraisal at financing had been slashed by about 70%, according to S&P Global, which cut its ratings on the bonds well before losses occurred.

The hit to bondholders came after the property loan sold at a steep discount in April to a developer looking to kick-start an office-to-residential conversion at the building.

Office-building prices have plunged an estimated 37% from peak levels in March 2022, according to Green Street’s April commercial property price index, while overall prices for shopping malls, apartment buildings and the like were pegged as 21% lower.

“There is going to be more distressed bonds, more assets coming to market,” said David Auerbach, chief investment officer at Hoya Capital Real Estate.

Yet while others worry about the carnage of discounted sales, Auerbach expects high-quality distressed properties to find willing buyers. He pointed to large amounts of cash on the sidelines and recent REIT earnings calls that suggest leasing activity has picked up and property prices may have bottomed.

Why AAAs matter

In the wake of 2008, bond issuers and credit rating firms underwent a series of reforms after billions of dollars in toxic mortgage bonds and related derivative transactions imploded, which originally were stamped with coveted AAA ratings.

The reforms diminished the industry’s reliance on credit ratings, but Wall Street and borrowers continued to heavily rely on AAA ratings to achieve one of the market’s cheapest sources of property financing.

Furthermore, top credit ratings helped attract the broadest possible base of investors, a feature that has allowed issuance in the roughly $700 billion commercial mortgage-bond market to flourish in the past decade of low rates. The bulk of that debt was rated AAA, with smaller slices rated A to as low as BB.

But as the Fed has kept interest rates higher for longer, more investors appear to be giving up hope of recouping their full initial investment.

According to the latest quarterly filings, exchange-traded funds and mutual funds were valuing more than 100 positions in $214 million in commercial mortgage bonds at prices as low as $25 to $35, according to a tally from Empirasign, which tracks trading in the market. A $100 price reflects an expectation of being repaid in full.

Furthermore, CrediQ identified about $67.5 billion worth of single-asset, single-borrower bond deals with office exposure. Of the total, about 15% were reporting a debt service coverage ratio below 1.10x, which is a popular debt metric lenders use to determine whether a borrower can qualify for a new loan or a refinancing.

Any property with a 1.0x debt coverage indicates the building is only breaking even, when looking at operating income versus debt service obligations.

That backdrop, coupled with higher rates, makes it tougher for borrowers to refinance. It also has investors bracing for more potential losses on top-rated bonds.

“There’s definitely a roster of deals where we see risks going up the capital stack,” Goodson at Voya said.