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Is the Distress Here Yet?

February 10, 2023

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Conditions are rising that should cause a lot of CRE distress. How will it all shake out?

Back just in 2020—how long is that?—the fear in commercial real estate was palpable. The pandemic was full on. States and cities were closing businesses. Many office buildings became ghost towns. People were without incomes. Who would pay the rent and, through that, the mortgages? The tax bills? Insurance? Forget profits. How would anyone stay in business? And who would scoop up all that distressed property?

Then the government troops came roaring in. A congressional cavalry authorized massive amounts of aid for big corporations, small businesses, and individuals. The Federal Reserve opened the taps, bought corporate bonds to stabilize markets, injected liquidity at rates never before seen, and dropped the benchmark rate down to nothing.

The economy took a beating … and quickly turned around. A wave of distressed properties came along.

But the government support has gone, inflation, chased by rapid interest rate increases, came along, and now the industry is back wondering when the wave of distress will happen.

“I think there are definitely going to be challenges during 2023 and there will be properties that you would see as distressed,” Cydney Gurgens, executive vice president and director of commercial real estate at UMB Bank, says. Many will find themselves pressed between the need to refinance and the inability to get the rates and loan-to-value ratios that were the basis of their business models.

Hard to say how many will be in that sort of position, but it looks like something could happen. The question is when and how extensive.

GIANT PINCERS The pressures being felt have long been coming. Since the 2008 global financial crisis, central banks around the world have tried to generate economic growth by lowering interest rates. The Fed did as well, although avoiding zero rates as well that was done in some other major economies. But it was cheap money for about 15 years as a roaring recovery never happened.

Instead, inflation stayed low, even as over time jobs returned and then unemployment kept dropping. Ultra-low interest rates were terrific for anyone looking for financing, like CRE professionals. But the move decimated fixed income investment. Stocks shot up in value but be-came increasingly expensive. Investors needed alternatives and real estate became a choice place to park money.

Two things happened. One, massive amounts of capital began to amass, often from funds that had never done much in commercial real estate before. Second, all that money was a demand frenzy at the CRE supply boutique. Prices went up. Cap rates went down, and rents had to increase to accommodate the expectations being created.

“The safest assets at the beginning of the year were probably multi-family and industrial,” says Adler & Stachenfeld chairman Bruce Stachenfeld. “They were trading at about a 3 cap, 3.5 cap. They were leveraged at 60%, 70%. They were trading like bonds.” The higher the price, the lower the cap. And the more the leverage.

“Now interest rates go up,” Stachenfeld continues. And because these act like bonds, higher interest rates mean higher caps—and lower property valuations. “Now the loan to value is 90%. The asset is in a distressed situation.” The lender wants that leverage paid down. If the buyer and investors kick in more capital, things are fine. But someone might not be able to pay it down, or backers might not want to.

“Happily, I don’t have any clients that are in trouble,” Stachenfeld adds. “However, I’m pretty sure that every client that has legacy assets has some assets that are troubled.”

There were also problems beyond easy money and high leverage. “What you had six months ago was a lot of buyers wanting to buy for the sake of buying,” Gautam Goyal, CEO and co-founder of private equity Three Pillars Capital Group that invests in Class-B and -C multi-family, says. “You had rents going up without doing any added value. Anyone who paid market rates for assets in the last 12 months that have little value-add in their property and have a floating rate on their assets once the rate caps expire.”

The math is relentless. “We talk to insiders all day who provide loans,” Goyal continues. “These are capital market guys and that’s the consensus. You’ll have interest rate caps that will protect operators for a certain amount of time. But once those caps expire, you were paying 4% or 5% interest rate and all of a sudden you have to pay 7.5% on a $30 million loan. That’s a 2.5% hike on $30 million, or $750,000 a year. That’s $62,500 a month.” Tenants had better think there’s enough value in the property to pay more.

It’s also not a problem that just appeared. “It took the pandemic to bring in something that was already overbooked,” like hospitality and office, says Richard Rubin, CEO of Repvblik, which adopts distressed properties.

HOW BAD MIGHT IT GET At the moment, there hasn’t been a rush of problems. “Rates are still historically low if you look at a long-enough time frame,” Dianne Crocker, principal analyst at LightBox, tells “Things have been very good for a very long time and before Covid we were in a record-long expansion. This readjustment comes as a shock to many who are used to market conditions being pretty good. But in terms of distress, I think it’s too early to predict and too early to use a term like a wave. I think a forecast of a wave of distress rarely materializes.”

However, the Fed’s interest hikes, and the response from markets, lenders, and consumers, are still in their early days. “Next year we’ll start to see loans originated three, five years ago [come due] and the market conditions are now obviously very different,” Crocker says. “The rates were much lower. Investors will have to adjust their capital structures. For some, the numbers won’t work, and the lender will take a loss.”

Or they could take a loss. The major banking regulators—including the Federal Reserve, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the National Credit Union Administration—seemed to be setting the groundwork for what might be coming. They had proposed updates for new accounting standards to a 2009 policy addressing commercial real estate loan accommodations and workouts. “The proposed statement would build on existing guidance on the need for financial institutions to work prudently and constructively with creditworthy borrowers during times of financial stress, update existing interagency guidance on commercial real estate loan workouts, and add a new section on short-term loan accommodations,” the proposal said. “The proposed statement would also address recent accounting changes on estimating loan losses and provide updated examples of how to classify and account for loans subject to loan accommodations or loan workout activity.”

“The other big question is how the property values have changed since the loans were originated,” Crocker observes.

Very big question. When some property values start to fall, that affects comps and valuations of others. Then there’s the potential for a downward spiral, even if shallow, where suddenly properties aren’t worth what they recently were. At that point, lenders have to see whether lending covenants on such metrics as loan-to-value are still in place.

“I think 2023 is going to be a tough year,” Fred Knapp, Transwestern Ventures managing partner, says. “I think everything’s going to stop. I think we’re going to see a tremendous amount of distress. It depends on the lender. The special servicers and CMBS has matured and been through a cycle with a financial crisis. I think balance sheet lenders, the life insurance companies and banks, they don’t want to take back the real estate if they can avoid it.” None of them want to operate properties, but they might have to. “If value has been impaired to a point that it’s not going to come back, they may not have a choice,” he adds.

WHO MIGHT BE ON THE LIST It’s the CRE equivalent of Santa’s naughty and nice list.

“If you were to ask me which asset classes are likely to experience greater distress than others, it’s not going out on a limb to say the most distressed will be office and retail,” says Crocker. “In both of these sectors, the story post-Covid is still being told, it’s still unraveling. There’s still tremendous risk and tremendous opportunity.”

“If rental rates are rising, even if cap rates are rising, there is some hedge to property values there, where those values could potentially hold,” Knapp says, agreeing. “From an office standpoint, it could be challenging.” Will hotels be okay with more travel? That might depend on whether business travel comes back. But there’s no sudden insight or rescue. Instead, the pressure may continue to ratchet up.

“There’s nothing to indicate that the Fed’s going to take the brakes off. If anything, they’ll accelerate,” Knapp observes. “We’ve already seen lenders pulling back. I think you’re going to see a lot of development go on hold unless it’s demand driven by tenants in a longer-term business plan. If you have capital, it’s a good time to be an opportunistic lender. I think it’s pretty obvious that we’re heading for a recession. It’s just a question of how long that lasts.”
“We’re not at a point today where no one is making a loan, but the availability of that capital has dried up significantly,” he adds. “At the leverage levels you previously could borrow at, they’re not available.”

For those with capital, the opportunities could be big.

“I’ve never seen better stock come to our door,” Rubin says of potential properties to convert. “We’re not a massive institutional operation. We’re a small, nimble, entrepreneurial business that likes to work on housing.”

Rubin’s seen 5-star hotel properties changing hands. Not their cup of tea because they wouldn’t pay the premium, “but in our little market universe, we are getting offered quality and location of assets that I wouldn’t have anticipated being offered. In the Southeast, in the Pacific Northwest. We’re managing to take advantage of these types of opportunities.”

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