The commercial real estate (CRE) industry, already facing challenges with economic uncertainty, the shift to remote work, and recent layoffs by many major office tenants, now confronts additional headwinds: higher interest rates and plummeting pricing.
Over the next two years, the CRE market will experience a record amount of over $1 trillion in loans coming due. A significant number of these loans were secured in the past five years when interest rates were lower, and a majority of these loans are held by banks. As a result, owners now face the challenge of refinancing or extending property-level loans for investments with a decreased net asset value (NAV) in a higher interest rate market. Refinancing today will often require additional capital, making it more costly than borrowers originally projected due to the combination of higher interest rates and lower valuations.
The failure of Silicon Valley, Signature, and First Republic banks further disrupted the market. Bank exposures continue to balloon as the ratio of real estate loans to regulatory capital (a key variable for regulatory examiners) continues to grow. Further pullback by regional and community banks is expected to materially reduce commercial real estate credit availability, with no obvious lower-cost replacement lenders in sight, according to PIMCO.
Commercial Real Estate in 2023: Key Issues for Financing
Historically, CRE owners have relied heavily on banks for financing. As recently as year-end 2021, banks and other lenders were more than willing to lend. Now, options to finance an acquisition or refinance a property have narrowed considerably, resulting in a drastic change in liquidity making it difficult for borrowers to secure any loans. This situation is forcing private real estate owners to look more closely at their regional bank exposure and make sure banking relationships are intact and diversified. Banks will want to work with owners/borrowers when refinancing is required. Banks generally do not want to own real estate assets, which means banks may be willing to work with borrowers when a loan comes due. Modest to large loan paydowns may be necessary, and short loan extensions are a likely near-term solution.
However, for assets that are severely impaired, banks may be less willing to negotiate, and a more significant restructuring of the debt may be required. This will be costly to the borrower, and many borrowers may choose to give back the assets and write the remaining NAV to $0.
Despite the challenging environment, many experienced and cycle-tested CRE owners are working with their relationship banks to find creative restructuring options. Some owners are finding solutions through bank negotiations, bridge financing, or by investing additional equity. However, some borrowers are unable to meet their loan obligations, particularly with office loans, given the challenging conditions in the sector. This has resulted in office loan defaults with a high likelihood of more to come.
There are usually other lending options in the real estate market, such as commercial mortgage-backed securities (CMBS), but these are not available now as those markets have slowed down significantly. Additionally, CMBS are generally not as desirable as bank loans as there is often less flexibility in loan terms. The defaults to date in 2023 have primarily been financed with CMBS.
All of these factors affect the pricing dynamics of the real estate market. As CRE loans come due, for assets where owners are not able to refinance, pay down the loan, or sell the asset, owners may be forced to continue to lower the investment price to find a willing buyer. The owner’s alternative is having the bank take back the keys and search for a buyer for that note. If there is no buyer, the bank will be forced to decrease the price until it is able to offload the asset. Both scenarios lead to prices being pushed down.
It is up to the owner to handle communications by working with the lender years in advance of a CRE loan maturity. It means keeping the lender up to date on the business plan for the asset, including leasing progress and capital expenditure plans. It means treating the lender as a partner and not surprising them with negative operational news. It should be a long negotiation and conversation between the owner and the bank with the shared goal of not defaulting on the loan. Conversations around debt maturities and business plans for assets are much more detailed today than they were a short time ago. If owners have the capital and capacity to continue to hold assets until a better transaction environment, banks should be willing to wait it out with them. It may cost them both more than it would have during the era of cheaper money, but it is better than the bleaker alternatives.
In summary, higher interest rates, falling valuations, and changing demographic trends in today’s environment translate to many owners being forced to sell assets when loans mature. Given current macro, capital markets, and demographic trends, buyers today cannot confidently underwrite most investments, especially office assets, creating a wide pricing gap between buyers and sellers. As loans continue to mature and more distressed sellers enter the market, pressure will push pricing lower, potentially spurring transaction activity. Increased transaction activity will likely restore confidence in pricing and valuations, signaling a shift in the real estate market cycle, despite near-term challenges.
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