Lenders and borrowers prepare for a muted distressed environment

The US commercial real estate market is gearing up for what is expected to be a more measured downturn relative to volatile periods in past, as senior lenders retool their strategies to place more emphasis on solving for distress, refinancing and shorter-term debt deals.

Panelists at New York University’s Schack Institute of Real Estate Capital Markets Conference on December 6 – which included executives from Goldman Sachs, Blackstone and GIC, among others – said the sharp spike in interest rates caught the market and its forecasts offguard, creating a period of rebalancing heading into the new year.

Jeffrey DiModica, president at Starwood Property Trust, said prior to the US Federal Reserve’s moves to decrease inflation, the expectation was that fixed-rate borrowers would take advantage of generationally low interest rates and roll and get more tenor on their debt. “Since [rates were lowered in] 2007 and the fixed-rate debt borrowers [saw poor performance], everybody has become a floating-rate debt borrower, everybody is private equity, everybody wants less term and they want more proceeds out,” DiModica said.

Coming out of the historically low-rate environment amid what is perceivably a normal real estate world, today’s troubles would seem to be a quick patch of volatility. DiModica said instead there are huge number of loans rolling over in 2023 and pent-up stress yet to be resolved.

“There is a tremendous amount of distress, so you are going to roll out of a plus-or-minus 3 percent floating-rate mortgage into a plus-or-minus 8.5 percent mortgage, and there is going to be a lot of stress in the system,” DiModica said. He believes 2023 will be a different year compared with the initial onset of covid-19, when lenders and borrowers at least had an opportunity to be nimble and take advantage of rates.

Inflation benefits

Richard Mack, CEO and founder of Mack Real Estate Group, said today’s volatility differs from prior bouts in that lending demand is not spread across all asset classes in the current market. “We are going to see people who can hold onto the best properties [make] rents really increase through this period, and get the benefit of inflation if they can hold onto the asset,” he said. 

Mack said he expects the landscape also needs to see major restructuring on other assets that can’t meet the needs of the economy. With rent on those properties falling, there will be significant destruction in value, he added.

For Tim Johnson, global head of Blackstone Real Estate Debt Strategies, the bifurcation of haves and have-nots is not all negative. He noted inflation can benefit real estate with shorter-duration cashflows where rent growth can be captured in the short term and held onto over a longer term.

“That would be a differentiator in terms of where cap rates settle out for different asset classes, because some are going to continue to see a lot of growth and others are going to be a bit more challenged,” Johnson said. He explained the drop in commercial real estate supply is another factor affecting dealmaking in today’s environment, atop ensuring stable capital structures are in place to capitalize on the positive opportunities that do arise in a more limited market.

Widespread caution

Jesse Hom, managing director and head of real estate capital markets and credit investments at GIC, said the uncertainty in the commercial real estate debt markets is causing a paralysis because risks are now layered with higher interest rates, inflation and external headwinds such as Russia’s invasion of Ukraine.

“From GIC’s perspective, we have been macro-cautious for a while. The firm, from a top-down perspective, did a great job raising dry powder and de-risking in 2021. But the thing about de-risking is that you have to make two calls: you have to de-risk and you have to re-risk,” Hom said. He added GIC still views US real estate favorably and sees potential for great bottom-up opportunities arising from the stressed environment.

Miriam Wheeler, managing director at Goldman Sachs, said additional widening has been brought on by an incredibly depressed commercial mortgage-backed securities market. “CMBS started to crack in January of last year,” she said. “To the extent that you have the ability to tap any other market, people really did. They put a lot of product into the bank market and elsewhere.”

Wheeler said the CMBS market is still struggling from a firestrike where a lot of money managers who typically drive the market are on the sidelines until they start to see some macro stability and have a better sense of the Fed’s direction. “That said, we do think that CMBS has underperformed corporates. If you look at the firming that has happened in both the equity market and the corporate market over the last month or so, we think CMBS has lagged.”

Stability is expected to bode better for CMBS supply in Wheeler’s view. She said in the CLO market in particular, there will be rising demand for triple-A-rated issuance assuming the Fed tapers its pacing by the second half of 2023 and a more normalized market supply resumes.

Across each firm represented on the NYU panel, the one sector still lacking in favorability is office, even as retail and hospitality regain attention from senior lenders.

DiModica said the office market today is facing trouble, though there is time for the sector to work itself out across a number of major metropolitan areas based on lease timing and loan maturities.

Starwood, Goldman and others represented on the panel have all been more selective in their office allocations “There have been very few transactions on [Class A] office where you can get paid well enough,” Mack said.