There have been a lot of headlines recently about property valuations, interest rates and a potential credit crunch for commercial real estate. The great financial crisis of 2008 (“GFC”) is frequently cited as a potential guide to how this may play out for commercial real estate.
However, residential real estate during the subprime crisis is not a true comparable because whereas both commercial and residential real estate share valuation and financing risk, commercial real estate is an income producing asset. Valuations appear to be under pressure for commercial real estate but that alone does not result in a default by owners/borrowers.
One of the primary drivers of default for commercial real estate owners is a disruption in cash flow, which disruption may result in an inability to cover debt service through the life of the loan (known as term default) and/or the inability to repay or refinance at loan maturity (known as balloon default).
With respect to the first risk, cash flow is foundational to commercial real estate valuation. A property’s cash flow can be disrupted by lack of demand as leases roll over, leaving vacant space in a building, and/or tenant payment default. Depending on the severity of the tenant default, a landlord may have protections against the rent disruption in the form of a security deposit or a lease guaranty. If there is adequate demand for the premises, these mitigants could bridge the gap between the nonpayment of rent and leasing the space to a new tenant.
The question of demand has been frequently raised with respect to the office asset class, as companies assess their need for space given the recent shift to hybrid or even fully remote work arrangements. These concerns are impacting office valuations nationally. There is some hope in that for the majority of office property, leases are longer term, often with rollovers evenly distributed, and cashflows remain sufficient to cover current debt service. Despite valuation concerns, a wave of term defaults in office properties is seen to be unlikely in the near term which is in stark contrast to the experience of residential mortgages during the GFC.
The second concern is refinancing risk. The refinancing market is expected to be the most challenging for commercial real estate since the GFC. This is partly driven by the recent tightening of monetary policy by the Federal Reserve, with ten rate hikes over the past year. It is estimated that the size of outstanding debt secured by commercial real estate is approximately $4.4 trillion, of which $728 billion matures in 2023 and $659 billion matures in 2024.
Office is important to highlight, as noted this property class has experienced significant valuation declines potentially driven by the reduced needs for office space by tenants. While the trend for less office space began prior to the pandemic with open office space plans and hoteling concepts, the shift to hybrid and remote work has exacerbated this issue for owners. This can result in lower rents, higher vacancy rates, and pressuring office valuations with industry estimates placing valuations down from the peak by between 30-40%. The likely result is lower appraisals at refinancing which reduces the loan amount a lender’s loan to value requirements will support. It is estimated that in 2023 the total refinancing needs for office properties is approximately $180 billion.
Refinancing this maturing debt at a lower loan amount requires the borrower to bring money to the closing to pay down the difference between the amount of debt maturing and the amount the lender is willing to lend based on their loan to value requirements. However, this assumes that there are lenders willing to refinance this debt to begin with, something that is becoming increasingly uncertain with the ongoing banking crisis which threatens a tightening of availability of funds. The banking crisis has the potential to create a credit crunch both in terms of how it impacts the economy and as a source of lending for commercial real estate loans.
The GFC provides precedent in addressing the upcoming loan maturities, which is that the existing lenders may extend the loan rather than calling the maturity. This allows both borrowers and lenders to wait out the current uncertainty in hopes of refinancing in a more stable economic situation. However, circling back to the first risk factor, this is less likely with respect to any given loan with an existing term default.
While uncertainty and risk persist in the commercial real estate sector, it seems two likely outcomes in response to the upcoming commercial real estate loan maturities are that the borrower will refinance and put additional equity in to the property or both parties will agree to a short-term extension of the existing loan, the latter of which was common practice during the GFC.