(Bloomberg) -- Near-empty office buildings, already a problem plaguing US cities, are becoming a worry for mortgage bondholders as landlords fall behind on repayments at the fastest rate in five years and the difficulty of refinancing the loans grows.

The work-from-home phenomenon spawned by the Covid-19 pandemic and a slowing economy are pushing tenants to cancel or not renew leases, making building owners miss loan payments. More than 4% of office loans packaged into securities were at least 30 days in arrears as of May, the highest level since 2018, according to a recent report from real estate data firm Trepp. 

The rise in delinquencies is leading some investors to avoid commercial mortgage-backed securities with too much exposure to office buildings, in turn causing some CMBS yields to spike. Slack demand may make matters worse for real estate borrowers who anticipated refinancing almost a quarter of mortgages on office buildings this year.

“This is just the tip of the iceberg for office delinquencies as $35 billion in CMBS office loans are scheduled to mature this year and the refinancing market is effectively shut to this asset class,” said Dan McNamara, founder of Polpo Capital Management. Polpo is betting against securities backed by office loans. 

Brookfield Corp. and a Pacific Investment Management Co. office landlord are among major institutional owners that have defaulted on large office mortgages this year. A venture started by WeWork Inc. and Rhone Group defaulted on a loan for a San Francisco office tower. 

The loan defaults raise the specter of missed payments to holders of commercial mortgage bonds. Delinquencies for all loans in commercial real estate securities jumped the most last month in almost three years, according to Trepp.

In May, Kroll Bond Rating Agency said it is looking at downgrading securities tied to 11 commercial mortgage bonds, because the bonds are backed at least in part by office properties that are weakening. Should Kroll decide to cut its rating on all the debt, it would be its biggest such action since July 2020, early in the pandemic.

For their part, CMBS investors say the shaky loan environment is pushing them to buy only deals backed by high-quality loans. The dropoff in demand all but shuttered the new-issue market earlier this year, and debt sales are down by almost 80% from this time last year, according to Bloomberg data.

Several recent deals were noticeable for the relatively small number of big office building loans in the pool of mortgages being packaged for sale. Also, borrowers and underwriters have become more flexible in tailoring new issues to meet investor concerns, said John Kerschner, head of US securitized products at Janus Henderson Group, in an interview. 

“Office exposure in conduit deals has gone down this year, and if bond buyers are uncomfortable with specific loans and the issuer wants to get the deal done, they may very well take it out of the pool,” Kerschner said. Conduit transactions repackage different types of mortgages, including offices.

Existing debt that rebundles a variety of commercial real estate loans is yielding among the most in over a decade in the secondary markets, over 5.5% in recent trading sessions, according to one measure.

“Most of the risk is already priced in,” Kerschner said. “Investors who worried about offices left the market earlier and the rest is moving up the capital stack in general, looking for the investment-grade portions of the bonds.”

©2023 Bloomberg L.P.