Blackstone Inc. and KKR & Co. mortgage real estate investment trusts are grappling with deteriorating office loans as higher interest rates and weak demand drive down property values. 

Blackstone Mortgage Trust Inc. downgraded 13 loans during the first quarter, seven of which were backed by U.S. offices, and took on the legal title to an office building in Mountain View, California, according to an earnings report and a conference call Wednesday. KKR Real Estate Finance Trust Inc. said three of its eight loans on its watchlist are office debts. 

“We continue to address the ongoing credit cycle and reset in office values,” BXMT Chief Executive Officer Katie Keenan said on the earnings call Wednesday. “The recovery will take time, with additional reserves and losses along the way, as we’ve seen this quarter. But BXMT is well-prepared to navigate this period.”

Office properties have been walloped as higher borrowing costs weigh on valuations. Landlords also face weaker demand for space in certain markets with the rise in remote work. But transactions in the market have started to pick up after being largely frozen in 2023. One property in downtown Los Angeles sold for about 52% less than its 2018 price.

The loan challenges cropped up in the mortgage REITs’ profitability, with both BXMT and KREF reporting lower distributable earnings per share in the first quarter compared to a year earlier. Shares of BXMT dropped 4.9% to $18.19 at 2:28 p.m. in New York Wednesday, while KREF’s stock fell 2.1% to $9.81.

Executives at KREF said the trust has largely spotted the risk in its office loans and been working through the issues. A KREF spokesperson declined to comment beyond the earnings call.

“The office sector remains challenged, though we are beginning to see more liquidity now than six months ago,” KREF CEO Matt Salem said on an earnings call Wednesday. “In KREF’s portfolio, we continue to feel we have identified the potential office issues within our watch list and do not anticipate further negative ratings migration to the watchlist from the office sector.”

BXMT executives said the mortgage REIT is taking a proactive approach as it addresses impairments and 92% of its portfolio of loans is considered performing. The trust has near record liquidity levels and collected more than $1 billion in repayments during the first quarter, according to its earnings report.

Strong economic and inflation reports have pushed out the expectation for the timing of potential rate cuts by the Federal Reserve, ratcheting up the pressure for borrowers. That could complicate the refinancing talks for loans that received one-year extensions last year and may need to be renegotiated while rates remain high, according to BTIG analyst Sarah Barcomb.

“Higher-for-longer rates, while good for income as a floating-rate lender, put additional pressure on borrowers,” BXMT’s Keenan said on the earnings call. 

But the pickup in sales and liquidity in the commercial-property market is starting to make the situation more clear, helping borrowers pick a path for the properties—whether that’s through sales, refinancing the debt on the buildings or just moving on, Keenan said.

“While the timing of the cycle will remain dynamic,” Keenan said, “we believe 2024 will bring additional clarity to the market and our portfolio.”

This article was provided by Bloomberg News.