It was apparent early in 2023 that the coming year was going to be a challenging one for commercial real estate sponsors, particularly those with near-term debt maturities.
The issue was simple to understand, but difficult to solve: how were sponsors going to be able to refinance near-term maturities when interest rates were significantly higher than they had been just a year or two earlier?
The impact is now starting to be seen, as lenders, master servicers and special servicers are reporting upticks in problem loans.
Berkadia, a New York-based advisory firm that oversees a 21,000-loan commercial real estate portfolio totaling nearly $400 billion, has started to see an uptick in transfers to special servicing over the past six to nine months. “Most of the transfers to special servicing have been for monetary or imminent monetary default,” says Julie Gschwind, a senior vice-president of portfolio surveillance and special servicing.
“The challenge right now is that you have some dislocation in fundamentals depending on the product types, but across the board you have a real valuation issue across all product type, regardless of fundamentals”
The firm is seeing the greatest number of issues in the office, healthcare and single-family rental sectors, with Gschwind noting that many of these issues are related to the long-term impact of the covid-19 pandemic, rising interest rates and increasing vacancies.
“Office properties have been significantly impacted by the shift to remote work, healthcare properties are seeing declining occupancies and increased expenses due to covid and the SFR segment is still having problems related to tenant protections and eviction moratoriums,” Gschwind says. “The only asset class where we haven’t seen a lot of transfers is in the multifamily sector, and the [transfers] we have seen are mainly due to property condition issues.”
Ahead of the maturity wall
Defaults and delinquencies are expected to rise as sponsors come up against a heavy wall of maturities over the next two years. Data from the Mortgage Bankers Association provides a comprehensive snapshot of pending maturities over the next three years, with about $728 billion coming due this year and another $659 billion slated for maturity in 2024.
In addition to interest rates, which are more than 500 basis points higher than they were prior to March 2022, when the Federal Reserve began its current cycle of rate hikes, sponsors and lenders are having difficulty figuring out where valuations are, says Joe Gorin, a managing director and head of US real estate for Charlotte-based investment manager Barings.
“The challenge right now is that you have some dislocation in fundamentals depending on the product types, but across the board you have a real valuation issue across all product type, regardless of fundamentals. This is creating a real complexity in terms of how to transact. We are finding ourselves in this moment of paralysis,” he says.
There is a consensus among market participants that the office market is facing unique challenges stemming from a protracted work from home environment following the pandemic. Data from KBRA showed that in June, 50.8 percent of the loans transferred to special servicing were in the office sector. Moreover, New York-based data provider MSCI is tracking continued slow activity in the office sector.
This lack of activity makes it difficult for market participants to move forward with transactions in the office sector. “The difficulty is estimating what market value really is,” she says. “Nothing is trading, and appraisers can’t even tell you what the value is,” Gschwind says.
Thinking across platforms
Jeff Davis, director of portfolio and asset management at advisory Northmarq, says the firm is seeing all lenders taking a hard look at their portfolios, especially office exposure. “They are trying to be very proactive about having discussions with sponsors earlier in the process. They aren’t waiting for a loan to go delinquent to start communicating with sponsors,” he adds.
Barings’ Gorin underscores that asset management has always been critically important, regardless of the market environment, but especially now. “Asset managers have to be focused on capitalization and debt maturities, and not just those from six months out. They need to look out over the next two years because a lot of these loans were financed in a different time and place,” he says.
Managers like Barings, which invests across debt and equity, are thinking about asset management across platforms. On the equity side, the question is often around value-add benefits of investing significant capital into office repositioning and accretive leasing, Gorin says.
“On the debt side, if you’re concerned about your sponsorship or your borrower not being able to perform, then those debt asset managers have to get under the hood and think like an equity asset manager about what value could be like down the road. The asset managers need to ask, ‘Are we going to be forced to take the keys back here? Or put a creative structure together to extend the debt and live to see the value creation on the other side?’”
Tingting Zhang, founder and chief executive of El Segundo, California-based TerraCotta Group, notes that while lenders and sponsors are taking a hard look at their portfolios, it is too early to predict how the current distress will play out.
“Given the fact the interest rate is unlikely to go back down to zero in the near term, purchase transactions that occurred in the past three years would see value erosion in the new cap rate paradigm. Lenders and assets managers with a problematic portfolio will be pressured to sell distressed assets at scale, as the value loss would likely persist,” she says.
The retreat of regional banks has exacerbated the scarcity of capital in commercial real estate, a phenomenon which has suppressed distressed offers. “The consummation of distressed asset sales will be a prolonged and painful process until seller and buyer find a meeting of the mind in the new pricing paradigm,” she adds.