We have all observed that office vacancies, interest rates increases, regional bank distress and a general tightening of credit have caused even some of the largest and most sophisticated commercial real estate owners to have properties at risk. Behind grandiose headlines, though, lie some of the most material and diversified default risk and capital markets challenges our team has seen in commercial real estate for years.
Tens of billions of dollars in debt is coming due this year on properties with broad-based occupancy levels below 80%. Many owners of class-B properties are seeing occupancy levels dipping below 50%. It has been estimated that $1.5 trillion in commercial real estate debt will come due over the next three years. Despite recent economic resilience, slowing economic growth, sticky inflation and tighter financing conditions will continue to push default rates up.
We remain cautious on office because we view the sector as in only the early stages of a multi-year secular headwind. Additionally, we are cautious on lodging and retail because both sectors are more susceptible to a downturn in economic growth.
Given market volatility, and from our experience across market cycles over the past 25 years in the real estate industry, we strongly encourage our owner and operator clients to proactively engage in capital market discussions well in advance of imminent capital needs. Approaching the market early allows for a thoughtful assessment of options, and avoids both the risk of a material shift in capital market conditions and the risk of loss of negotiating clout due to an urgent need for capital.
In our assessment, the full impact of sharply higher interest rates is yet to be realized. The U.S. regional banking sector’s collapse is a reminder of how quickly confidence can erode and emphasizes the importance of acting early because downside risks have increased. Tighter financing conditions, combined with more conservative lending standards, the “extend and pretend” and “delay and pray” tactics that certain borrowers employed during prior cycles are particularly risky given current market conditions.
Oberon’s real estate team witnessed numerous borrowers who delayed forced into bankruptcies or “vulture financings” on very unfavorable terms. We have every reason to expect comparable unfavorable results in the current cycle. In contrast to those who faced bankruptcies or vulture financings, those who were most successful tended to not only engage early and proactively with the market, but also: (1) had a clear and realistic assessment of portfolio values and market conditions supported by appraisals or similar valuation materials; (2) exhibited flexibility on proposed capital markets solutions (i.e., rather than insisting on, for example, a common equity investment); (3) dedicated appropriate internal resources to promptly and thoroughly addressing capital provider due diligence requests; and (4) employed experienced investment bankers. A recapitalization and restructuring transaction most often benefits from a highly experienced advisor guiding clients through the processes and issues in such transactions.
Restructuring capital real estate transactions, often structured with both debt and equity, may present a number of important considerations for existing owners.
Oberon’s real estate group serves as a financial advisor to companies, financial sponsors, lenders, creditors and other interested parties in distressed and tenuous situations. We continue to see, for the time being, a broad-based availability of capital across the capital stack—though numerous common investors have pushed their focus up the capital stack to preferred equity, mezzanine debt and senior debt. High interest rates will likely further strain credit financing costs, leverage ratios and asset valuations, so it is imperative owners and borrowers engage the market proactively and intelligently.
Alex San Andres serves as managing director with Oberon Securities.