Commercial real estate lenders are dusting off old playbooks to deal with a growing pipeline of bad loans.
Earlier this month, Westfield made headlines when it confirmed that it was handing back the keys to the San Francisco Center, which backs about $560 million in CMBS loans. The mixed-use property includes both office space and a mall, with occupancy rate that has dropped sharply with the loss of key tenants such as Nordstrom, Old Navy and H&M.
It’s just one example of recent anecdotes of owners walking away from assets, but in many more cases lenders are hoping to get borrowers back to the bargaining table to work out solutions that don’t end in dreaded “jingle mail.”
“The goal is not to take something in, foreclose and sell it. The goal is still to work things out and deal with cooperative borrowers and try to get them back to performing status,” says Joseph Cuomo, a senior managing director at Ten-X, a CoStar Group company. Cuomo estimates that 75% to 80% of distressed loans do get worked out. “Even coming out of COVID, there wasn’t a mass liquidation of retail and hotels. So, I think there’s going to be a lot more workouts, loan extensions and modifications,” he says.
The volume of distress is clearly on the rise. A recent report from MSCI Real Assets estimated that $64 billion worth of commercial real assets were distressed as of the end of the first quarter with another $155 billion’s worth of potentially troubled assets in the queue. In terms of CMBS loans specifically, both the CMBS delinquency and special servicing rates spiked in May, to 3.6% and 6.1%, according to Trepp. Retail is reporting the highest delinquency rate at 6.7%, followed by lodging at 4.3%. But what is concerning is that office stress appears to be accelerating, jumping 125 basis points to 4.0%.
“There is a lot of talk about office, but people are going to be surprised about the disruption they see in sectors such as multifamily that people were not expecting,” says Scott Larson, managing principal, Pangea Mortgage Capital in Chicago. In the past few years, there was some aggressive buying with business plans that would work only if a sponsor was able to precisely hit every piece of their projections. They may not have accounted for higher debt costs or softening fundamentals that some markets are experiencing, he adds.
Heading for the exits
In a market where capital costs are higher and liquidity is tight, one strategy for a distressed owner is to sell an asset before the loan matures. Ten-X is seeing potential deals of this type for its auction platform. However, the expected valuations aren’t always meeting owner’s expectations. For example, if an owner has $6 million on a loan balance, they might take a wild swing and try to get $8 million selling the property, even if the market value is barely at the debt level. “You can’t bring a deal to our platform hoping for a miracle or a magic show,” says Cuomo.
Ten-X also is getting calls from owners who have their lenders in tow. Rather than going through a lengthy workout or REO process, both sides have agreed to sell the asset and jointly cut their losses. “We’re seeing more of what I would call a lender-involved short sale,” notes Cuomo. There is a recognition that the borrower has lost equity and the lender also is going to take a loss, but there is a willingness for both sides to come together to expedite a resolution, he adds.
In addition, loan sales were common during the Great Recession, but have been slow to emerge in this cycle, at least so far. During the years between 2009 and 2013, Ten-X completed nearly 2,000 loan sales over that period compared to the current average of about eight to 10 per year. Selling a loan is typically a quick way to get a loan off the books with deals that can close in about 10 days versus a more lengthy receivership and REO sale.
Lenders appear to be very patient, notes Cuomo. Banks in particular don’t seem to be moving into panic mode or staffing up to handle distress. That could be due to the fact that many of the loans on their books are recourse loans that have significantly lower leverage levels compared to real estate loans during the Great Recession. The weighted average LTV on the loan portfolios for some of these very large banks is 45% to 50% versus 70% to 80% that were the norm in the Great Recession, notes Cuomo. “Outside of the office properties, a lot of people feel pretty well insulated by that low leverage,” he says.
Creative solutions
Given the added challenge of the higher rate environment, borrowers with properties that are underwater or on the bubble will have to make tough choices on whether they want to throw in the towel and sell an asset, potentially at a loss, or give an asset back to the lender. The other option is to dig in and hold onto properties and work with lenders to extend or restructure an existing loan.
“You're seeing a lot of foreclosures being started, but the intent is not to complete them but rather it’s an attempt to get borrowers to maybe agree to some sort of a workout,” says Bert Haboucha, a principal at Atlas Capital Advisors. The biggest problem today is that the value and the income have both dropped so precipitously that the borrower is basically going back to the lender and saying, “Why would I work anything out unless it involves a severe cut in loan balance.” On the office side, some owners don’t want to work it out. Their equity has been wiped out and they don’t see any upside from continuing to pay debt service, he adds.
In other cases, lenders and borrowers are coming up with creative solutions. For example, Atlas Capital worked on a loan workout for a retail center recently where the lender split the notes into an A/B structure. The property was originally valued at $15 million with a loan at $10.5 million. However, the value had dropped to about $10 to $11 million. The retail center was well located and starting to see leasing momentum following a rehab. However, the owner was not motivated to put more money in.
The two parties agreed to split the loan into an A/B structure where the A note was $7 million, 70 percent of today’s value and the B note was $3.5 million with the understanding that if the value didn’t clear a certain hurdle, then the borrower would not be on the hook for the B note if they had to sell the property at a loss, but the lender would get most of the money.
“The borrower is now motivated to clear the B note, but they know there is still an agreement that they get to keep some of the money. So your work isn’t for nothing,” says Haboucha “We’re seeing creative structures like that, and I think we’ll see more of those on bigger deals. And it won’t just be office product. It will be retail, apartments and even industrial where perhaps there was too much new supply or rents didn’t go up as much as was expected or maybe the loan was sized a little too high,” he adds.
Solutions vary depending on the circumstances and whether it is a recourse or non-recourse loan. “I think the smart lenders and the smart borrowers are forcing themselves to the table now before it gets to a deep workout situation,” says Larson. For lenders that have flexibility, particularly non-regulated lenders, some are willing to provide time in exchange for equity. If a sponsor is unable or unwilling to bring in fresh equity, some lenders may be willing to offer an extension in exchange for an equity piece of the deal. “I think that is going to be part of the playbook and arsenal for folks going forward that are able to do it, because they believe the business plan of the project, but they need time,” he adds.
Staying on top of problems
Lenders across the board are keeping a close eye on portfolios to stay ahead of potential problems. For example, CBRE Loan Services provides primary servicing on a commercial mortgage loan portfolio in the U.S. that is comprised of more than 14,000 loans with outstanding balances of over $310 billion. Although delinquencies remain low, less than 1 basis point overall for its entire portfolio, the group is preparing for an uptick in the coming months as maturities loom at the same time the Fed weighs alternatives for continued rate increases.
“Lenders are more vigilant now than in the past about increased surveillance on their loan portfolios and we are hiring more analysts to accommodate the increased workload,” says Chris M. Shamaly, executive managing director at CBRE Loan Services. During the Great Recession, fraud in the single-family sector combined with illiquidity in the capital markets combined to accelerate distress in the overall system. Although the same factors are not at play today, there is the potential for looming distress resulting more from monetary policy to stave off inflation even though the market remains liquid, he adds.
Pangea Mortgage Capital is a balance sheet lender specializing in providing floating rate debt to residential real estate, including multifamily, manufacturing housing and student housing. The company services all of its loans in-house, which means it is the first touch point for borrowers. “We’re definitely spending more time now than probably since Covid first happened, where we’re talking with our sponsors every two to three weeks to get updates, whether it is financial, operational or construction updates,” says Larson. “We’re really trying to stay in front of everything now, because everything is dynamic.”
People tend to forget that there has been a bull run in the real estate market for the past 10-plus years, which means there are a large number of decision-makers that have never encountered a downturn. What that means is that a lot of lenders don’t have that bench of experience to rely on, notes Larson. “So, the playbook is really reliant on who you have in your organization, and what your experiences have been and the ability to augment that experience,” he adds.