As values in commercial real estate (CRE) fall, global markets are concerned these properties may be the next banking domino to fall. More than $900 billion in CRE loans will mature through 2024, possibly creating a worst-case default scenario. Lenders already are more closely scrutinizing CRE assets when making financing decisions, with a particular focus on office properties.
Should that scrutiny become more stringent in the months ahead, it could contribute to additional erosion in the confidence in property values and the loan books that back those assets.
PwC’s Emerging Trends in Real Estate 2023 notes that valuations are weakening worldwide in the office sector, driven by higher interest rates, the potential for recession and companies reevaluating their leased space spending. Many companies continue to reduce their real estate portfolios in response to the rise in hybrid work, while tenants downsize or leave properties altogether.
These conditions have made it harder for property owners with maturing loans to refinance, and the banking turmoil of early ’23 has made financing even more challenging. That, in turn, has heightened regulatory and investor focus on bank portfolios of commercial real estate loans. Regional banks are an essential source of funding, responsible for nearly 30% of CRE lending activity. Meanwhile, commercial mortgage-backed securities (CMBS) underwriters also face difficulty pricing loans as market volatility and falling property valuations complicate hedging activity and secondary market trading.
Moreover, property owners will likely find lenders more restrained in underwriting lease rollovers and lease incentives, such as free rent concessions and tenant improvement allowances, clouding the outlook for a building’s future cash flows and valuation.
All told, further CRE valuation cuts appear likely, adding to the challenge borrowers face refinancing maturing loans or financing purchases over the next several months.
While we expect some lenders to be amenable to loan extensions and/or amendments, landlords could be forced to sell if it appears they won’t be able to refinance ahead of a loan’s maturity date. And if they can’t sell, they face the prospect of default.
Landlords and lenders should consider enhancing their policies and procedures as they navigate today's commercial real estate headwinds:
As leasing and sale transactions slow, there’s a decrease in the visibility and relevance of market data assumptions used in valuation models. As a result, lenders are more likely to reexamine property values ahead of financing transactions to protect their downside. Accordingly, as information transparency declines, firms are spending more time understanding market assumptions used in property valuations.
Credit monitoring and risk management are essential functions of portfolio management. The early identification of risks and deteriorating credit allows lenders to proactively manage their credit exposure. In addition, these credit monitoring activities help lenders identify deteriorating credit for financial reporting purposes — whether for CECL reserves or for loan valuations. These processes are essential to ensuring accurate financial reporting.
In light of recent bank failures, lenders may need to refocus their teams on understanding their liquidity profile, investment profile and the matching of liabilities and assets. In the near term, as lenders focus more on liquidity, there may be less CRE lending activity. Separately, for both lenders and investors, it’s essential to understand the refinance-ability of CRE assets.
For lenders: Refinancing may be a primary source of capital as loans are repaid upon exit. To the extent an asset is not refinance-able, or refinancing proceeds are unlikely sufficient to repay the loan, the lender should understand the regulatory ramifications of that exposure and engage with the borrower.
For investors: Understanding whether assets are refinance-able is essential to understanding investment strategies and liquidity needs. For example, if refinancing proceeds are anticipated to be insufficient to repay a loan in full, does the borrower have additional capital available to recapitalize the investment? If not, the borrower may be forced to raise other sources of capital or sell the asset. Regular monitoring will support portfolio-wide strategy assessment and asset management plans.
To get ahead of evolving conditions, strategically develop processes and identify any third-party vendors required to supplement the team’s depth and expertise to proactively manage portfolios. The up-front investment in operations, analytics, tools, templates and escalation mechanisms will help ensure that senior team member expertise can be appropriately leveraged, that consistent approaches are applied and that escalation mechanisms for proactive management exist if CRE stress spreads.
When considering various options, it’s important to consider the tax impact of any decision.
For borrowers, simply amending the terms of a loan can trigger a taxable gain or loss. In addition, having a debt relieved can lead to cancellation of indebtedness income. Lenders that acquire an interest in the assets used to secure a loan often aren’t structured in a manner that enables them to hold those assets in a tax-efficient manner.
Both borrowers and lenders need to assess tax implications early in the process so that they can be considered before terms have been agreed upon.
The full impact of the banking crisis on the commercial real estate market is yet to be realized. However, by sharpening your focus and processes with a refreshed playbook, your firm can be in the best position to not only successfully navigate current challenges but to create opportunities as a result.
1 Wiltermuth, Joy. “Office property woes could be tip of iceberg if credit freezes up as $1 trillion bill comes due; Roughly $900 billion of commercial real-estate loans come due through 2024, after an era of cheap debt,” MarketWatch, April 1, 2023, accessed on Factiva on April 19, 2023.
