Commercial real estate sponsors with maturing loans that were hoping to buy time and wait for a more favorable interest rate environment are increasingly finding that time is running out.
The sentiment of buying time was prevalent in 2023, with borrowers seeking bridge loans, in-the-money interest rate caps, pay and accrual loans, and a blend and extend strategy through which lenders are adjusting the rate on a loan in exchange for additional collateral.
But today, there is a greater realization that problems around maturing loans or other issues in the capital stack can no longer be put off, says Nitin Chexal, chief executive of Palladius Capital Management, an Austin, Texas-based real estate manager.
“As a lender, the question we think about when evaluating borrower execution plans is whether they should defend their position and hold on to the property or negotiate to modify a loan,” Chexal says. “That optionality exists for groups that are well capitalized.
But for other groups, they are at the end of their ropes and have run out of time.”
Pat Jackson, chief executive of Irvine, California-based manager Sabal Investment Holdings, believes last year’s interest rate increases combined with banks and other lenders that need to deal with troubled loans are forcing the issue. “Troubled assets that were on the edge have now fallen over the abyss.”
The multifamily factor
The multifamily sector, despite its defensive characteristics, could be squarely in the crosshairs of the coming distress. Of particular concern are the number of these properties that were sold in 2020 and into the first part of 2021, says Richard Litton, president of Norfolk, Virginia-based manager Harbor Group International.
“Late 2020 and 2021 was a very robust time for the multifamily markets. Cap rates were very low and the SOFR index was, for all intents and purposes, zero. There was a tremendous amount of transaction volume,” Litton says.
“Sometimes, you have to experience a fair amount of pain for the healing to begin”
Pat Jackson, Sabal Investment Holdings
Many of these buyers were using floating-rate credit from debt funds that had an initial three-year term. But as these loans start to reach the end of that initial term and the borrowers look to extend, they are often finding the cost of buying a new rate cap is prohibitively expensive.
“We are starting to see the first wave of those initial maturities expire and there is a very significant volume of that dynamic that will start to mature in 2024,” Litton says.
The expected dislocation, while painful, will be necessary for the market to reset, according to market participants.
“We believe strongly that in 2024 and 2025, there will be a shift through which true valuations will start to hit through,” Jackson explains. “Banks will start taking their medicine and the regulators will be a lot more rigorous in scrutinizing the balance sheets of banks at the loan level. Naturally, that will result in more distressed transactions occurring on a go-forward basis.”
There is a broad expectation that managers with dry powder will start to deploy, particularly as the US Federal Reserve is signaling a less hawkish outlook. Even so, the market is at a breakpoint, Jackson says.
“The writing is on the wall and things are not going to get worse in terms of carry cost, which should help the lending market and the capital markets. If you have an investment thesis and capital solution to make that work, you can come up with a price and a business plan.
“As painful as the global financial crisis was, it had to happen. Sometimes, you have to experience a fair amount of pain for the healing to begin.”