Three things to know about commercial real estate loan servicing

Distress is rising, but there are three important things servicers, lenders and borrowers need to keep front of mind.

Signs of distress are starting to increase in the commercial real estate market, with upticks in the number of loans being transferred to special servicing as lenders and sponsors grapple with the impact of 18 months of interest rate increases from the Federal Reserve.
As the financial markets grapple with the current period of rising interest rates, lower valuations and a significant number of near-term maturities, here are three things to know about what servicers are encountering – and how they are working through them.

1 Cash-in refinancings

In the past, sponsors used refinancing to take some cash out of a deal, giving rise to the term “cash-out refinancing.” The opposite is true today, with lenders and servicers expecting sponsors to put cash into deals to fill the gap caused by higher rates and lower valuations, says Christina Brodeur, a managing director at advisory SitusAMC.

“Lenders and servicers want to make sure borrowers have more skin in the game,” she says. “That could mean infusing more equity in a situation where there is an extension or modification, increasing reserves or even paying down a portion of a loan to right-size it. Lenders want borrowers to show they are committed to the asset, and they are also willing to be more forgiving and creative when structuring deals.”

2 Underwrite to memo

Office owners are often seeing substantial difficulty as they seek to line up new financing or refinance existing loans. The conventional wisdom in the market that part of the reason why lenders are often opting not to originate loans on office properties – even on well-leased, performing assets – is that they don’t want to have to do what is being called ‘underwrite to memo,’ or go through a lengthy approval process to get the loan approved.

“We are talking to lenders who see properties they would definitely lend on, but that the situation isn’t worth the trouble,” says Ron Chun, a senior managing director at New York-based rating agency KBRA. “This is creating some friction within the financing markets, even for better buildings.”

3 Stay live till ’25

A final mantra that is being embraced by market participants is the idea that it is necessary to buy more time, either for interest rates to lower, office occupancies to pick up or the lending environment to unlock. This is particularly true for the office sector, notes Kevin Shannon, co-head of US capital markets at New York-based advisory Newmark.

“In two years, especially for the office market, things will look better. We have been through a lot of downturns, and this is just another one,” Shannon says. “We are right in the middle of it, but I think that in two years, if owners can stay alive until 2025, things will look dramatically better.”

What’s next

Michael Franco, chief executive of New York-based advisory SitusAMC, says the current stasis will start to dissipate as there is a clearer path forward for interest rates and where specific markets and sectors are going.

“When you think about it, there is a lot of dry powder, and it is on the sidelines as a result of the uncertainty,” Franco says. “If you have new capital that you want to deploy, there is still such a wide bid-ask spread. There continues to be a large uncertainty premium that is keeping people on the sidelines and keeping bid-ask spreads wide.”

The hope, Franco notes, is that rates stabilize, the economy slows down and the Federal Reserve is able to cut rates slowly. “That is the happiest path for commercial real estate, that soft-landing scenario,” he says.