Prepare Now For A Roller Coaster Ride For Commercial Real Estate Properties
While many are applauding the efforts of the Federal Reserve to curb inflation by the raising of the interest rate, side effects or unintended repercussions are starting to surface. Much has been written about the effect on consumer credit card debt interest and residential mortgages, but not enough focus has been given to a looming tsunami with respect to US commercial properties' outstanding mortgage indebtedness.
According to a recent analysis from Morgan Stanley, almost $1.5 trillion worth of US commercial real estate debt will come due for repayment before the end of 2025. When most of these commercial real estate loans were initiated, interest was close to zero, and lenders for commercial real estate, recognizing that the owners were enjoying almost complete occupancy, were willing to lend with low fixed rate interest obligations. Commercial real estate owners were anxious to obtain refinancing and new financing at the time based upon the optimistic outlook of a combination of record unemployment, low interest rates, high commercial real estate occupancy and a decade of prosperity and the growth of the GDP.
Now, post-pandemic, everything has changed. Although unemployment remains at record low levels as a result of remote working being pervasive in most major metropolitan areas, the consolidation or shrinking of workforces (especially in the tech area), and the mushrooming of interest rates, commercial real estate landlords will be up against a wall when looking to refinance. Recent estimates show that 70% of commercial real estate mortgages were initiated and are held by small and regional banks. Additionally, it is estimated that these banks also own more than half of the agency commercial mortgage-back securities – bonds supported by property loans and issued by the US government-sponsored entities such as Fannie Mae which increase their exposure to the sector.
With the failure of Silicon Valley Bank and the emphasis that is now being placed on the financial health of small and regional banks, additional scrutiny and conservatism will preclude these banks from continuing to want to participate in refinancing of the fixed rate long-term commercial real estate lending. Since these banks have been the "go to" source of real estate lending, the pool of available funds for refinancing of the debt that is coming due will be shrinking considerably.
The Morgan Stanley report estimated that office and retail property valuations could fall as much as 40% from its peak less than five years ago.
Additionally, with interest rates now being close to fivefold higher than when these loans were originated, the underwriting standards for refinancing will change. With occupancy being lower which reduces cash flow and also places a greater burden on the landlord to support CAM for the vacant office space, lenders will be more hesitant to fully fund the to be refinanced debt.
For lenders who may be faced with these maturing loans, now is the time to consider what options are available for negotiation so that a default is not precipitated at or near maturity. With property values having dropped, every effort needs to be taken early in order to avoid a confrontation with the borrower. Under these circumstances, if a loan were to be close to maturity with the value of the property placing it under water with respect to the loan balance, lenders could face the possibility of borrowers seeking relief under Chapter 11 of the Bankruptcy Code to recast the loan to extend its maturity date and have the bankruptcy court value of the collateral so as to reduce the principal amount of the debt. This, then, creates what some call a lender's involuntary servitude in that the lender would now be forced to hold a loan with extended maturity, possible below-market interest rate, and a reduced principal balance.
With this unfortunate scenario looming on the horizon, now is the time to consult with a Tripp Scott professional to assist our lender clients and friends in developing a strategy so as to be able to maximize recovery and avoid unintended unfortunate consequences.
