Archives for July 2023

Lenders and special servicers are looking beyond refinancing options when it comes to working with borrowers on commercial real estate loans that are set to mature in the coming months and years, even as those loans increasingly are backing properties facing distress.

According to an analysis by Moody’s Investors Service, the percentage of real estate properties that use commercial mortgage-backed securities debt that are being refinanced is on the decline. Conduit refinance rates were 78.1% and 71.8% in the first and second quarter of this year, respectively, compared to 85.5% in 2019, the year before the Covid-19 pandemic and broader economy upended the commercial real estate market.

Matthew Halpern, vice president and senior credit officer at Moody’s Investors Service, said given the low interest-rate environment that existed before the pandemic, it wasn’t surprising to see so many loans refinanced then, especially if a borrower had a strong debt-service coverage ratio, which measures available cash flow versus debt obligations.

Interest-rate hikes imposed by the Federal Reserve over the past year in the wake of rising inflation have compressed real estate values. Add to that rising vacancy rates and a weaker leasing environment in especially the office sector, and the pressure has increased on building owners with loans coming due in the near term.

“Some loans are performing well from in-place cash flow but are unable to refinance,” Halpern said.

Lenders also have tightened standards in the wake of a more challenging economy and commercial real estate market, with some banks outright saying they’ve stopped new lending to office properties.

While fewer loans are getting refinanced overall, there’s been an uptick in the number of performing loans that are past maturity but haven’t been formally extended. That amount, negligible before the pandemic, reached 5.2% in Q1 of this year and 6.9% in Q2.

Halpern said that means the borrower is still making interest and principal payments as if the loan hadn’t matured — which typically suggests the borrower is committed to the property. Because the overall refinance rate has declined in recent quarters, the number of performing loans past maturity has naturally risen, he said.

The Moody’s analysis, which only examined CMBS loans, found 16.7% of maturing loans tracked by the firm were delinquent as of the second quarter. That share was much higher in the office sector, with 27.6% of office loans scheduled to mature in Q2 2023 considered delinquent.

Extend and pretend

What ultimately happens to a loan at maturity is entirely dependent on the nuances and financial performance of a property, not to mention the borrower. But “extend and pretend,” industry parlance to describe lenders extending terms on a loan for a property facing a loss in value instead of initiating a foreclosure, is being observed to some extent, according to industry analysts.

Moody’s found 2.5% of performing conduit loans set to mature in Q2 2023 were extended, down from 5.6% in Q1 2023 and more than 7% in the second half of 2022. Among performing conduit loans in the office sector, 1.3% were extended in Q2 2023, down from 10.9% in Q1.

Halpern said extensions aren’t a new thing in CMBS and, during a market dislocation, if a borrower is committed to improving its property, an extension on a loan is generally seen as better than a fire sale, he said. For an office property that’s historically performed well on quality, tenancy and cash flow but is facing a significant lease rollover in the next year or facing other imminent issues, a loan extension of one or two years, with the addition of a “cash trap” — a provision that would allow a lender to redirect surplus cash into an account it manages — could be put in place.

For some loans on the cusp of maturing, the ability to refinance may require more cash from the borrower, especially as lending standards have tightened.

Belinda Schwartz, executive chair, co-chair of the real estate department and partner at New York-based Herrick Feinstein LLP, said the “haves and have nots” have emerged as commercial loans mature. That sentiment is being observed among lenders and borrowers alike, as some owners have walked away from underperforming office buildings.

“There are certain people who have the ability to put capital into certain buildings, but then they’re picking their favorite children and saying, ‘Which are the assets where it make sense to put more money into, because it’s going to be worth it to do so?'” she said.

A lot also depends on a property’s capital stack and the its backers, Schwartz said. Bank lenders, debt funds and preferred equity players all have different models and potential willingness to take a distressed property back if a borrower defaults.

For building owners facing a looming maturity, it’s possible to work out a resolution if they have a good relationship with their lender or have a strong reputation in the industry, Schwartz said.

But the specific environment facing both the commercial real estate and banking world right now hasn’t been observed in past cycles, even in severe recessions like the global financial crisis of 2007 to 2009, making it difficult to ascertain what ultimately will happen with the wave of debt coming due soon. What’s happening now is only the tip of the iceberg, Schwartz said.

“This is a tough one because I’ve never, ever experienced this set of facts,” Schwartz said. “A lot depends on what happens in the bank industry more generally. The political climate is also complicated to navigate: Will the regulators find a way to help? I think there are so many unusual factors. … While my gut says (there’s) going to be a lot of pretend and extend, we are seeing a tick up in foreclosures.”

Source: “Fewer CRE loans being refinanced, but lenders find other ways to work with borrowers“

A new method of ranking industrial markets using a two-dimensional grid reveals changes over time in both sales volume and volatility and claims to offer new insight into risks that may not be apparent in traditional one-dimensional models.

The grid was developed by NAIOP. “This may help investors and developers create better strategies around market entry and exit, and to more easily identify markets that match risk and return objectives or merit further examination,” stated a report by NAIOP.

The report analyzes transaction volume and capitalization rates data provided by CoStar. It sorts industrial markets into two groups — the largest 51 markets, and the next largest 51. The vertical axis measures transaction volume and the horizontal axis volatility. The report uses this technique to compare the positions of large and mid-sized U.S. industrial markets at the end of Q1 2019 and Q1 2023.

“The grids reflect e-commerce’s continued positive impact on industrial markets. The largest industrial markets were more likely to experience increased transaction activity between Q1 2019 and Q1 2023 with fewer notable changes in volatility,” the report stated. Sharp transaction increases occurred in Orlando, Northern New Jersey and Las Vegas, while Kansas City dropped to the lowest level of the largest industrial markets with a decrease in accompanying volatility.

“On average, the 51 largest industrial markets in Q1 2023 experienced 30% higher volatility in cap rates and 22% lower volatility in transaction volumes compared to the second-largest 51 markets in the same quarter. Larger industrial markets attract more investors, which explains their greater liquidity, and may also explain greater cap rate compression and expansion during periods of economic expansion and contraction.”

The report noted that land scarcity limits the supply of new industrial space, affecting capital flows, while contributing to additional development in smaller industrial markets where land is more abundant.

Q1 2023 saw Durham, Palm Beach and Savannah join the list of the largest 51 industrial markets, replacing Charleston, Cleveland, and Harrisburg which dropped to the lower tier of industrial markets.

“Savannah’s growth is particularly interesting, as its rise into the largest 51 markets is an indication of its growing significance as a port city. Savannah’s location, including its proximity to Atlanta and to major rail lines and interstates, gives it a strategic position to serve 45% of the U.S. population,” the report commented.

Indeed, several Southern industrial markets grew in transaction volume, especially those in Florida, Virginia and Alabama. Bakersfield and other California markets also experienced growth as development moved inland due to a lack of development opportunities in Los Angeles.

However, some smaller markets dropped out of the second-largest set of 51 industrial markets altogether. Supply chain issues, pandemic effects or diminishing availability of developable land may have contributed to this trend.

“The largest office and industrial markets experience lower transaction volume volatility but higher cap rate volatility than mid-sized markets,” the report stated. “Investors and developers with shorter investment horizons may be attracted to larger markets for the greater liquidity they provide and their greater potential for cap rate compression when business conditions are favorable. However, these markets’ higher cap rate volatility also presents downside risks.

“Investors with longer time horizons may look to mid-sized markets, which generally offer lower cap rate volatility and higher yields.”

Source: “A New Way of Looking at Industrial Markets’ Volatility and Risks“

The commercial real estate market was headed for a nosedive. It seemed so obvious.

Landlords had been struggling to fill buildings left vacant after Covid-19 forced remote work.

Some commercial builders who had taken out loans to finance projects “were just walking away, giving it back to the lender,” recalls Quincy Krosby, chief global strategist for LPL Financial.

The Federal Reserve’s inflation-fighting rate hikes, beginning in March 2022, boosted the cost of loans.

Office space hit a record-high vacancy rate of 12.9% in the first quarter of 2023, up from 12% a year earlier, according to the National Association of Realtors (NAR).

That same quarter, the sudden failure of several banks spooked the public; in the aftermath, the Fed warned of tightening credit.

Predictions of a late 2023 recession have sparked concerns that businesses would be struggling to keep up with loan payments. In recent months, according to analyst reports, short sellers have been keeping a close eye on real estate investment trusts.

So where’s the crash?

The big plunge in commercial real estate valuations, analysts say, is more likely to be a long slide.

A CRE downturn “will be staggered,” says Krosby. Referring to banks’ preference for extending non-performing loans rather than writing them off, she says, “It’s the old ‘delay and pray.’”

Office Rents Still Rising In Many Metro Areas

Despite the vacancies, commercial real estate rents are continuing to rise, with the situation varying widely by city. According to a report by commercial real estate services company JLL, asking rents for office properties rose nationally by 0.3% between the final months of 2022 and the first quarter of this year.

But rents rose at a faster clip for fancier buildings in desirable locations, with some markets—including Charlotte, Nashville and Orange County, California—seeing record-breaking transactions, JLL said.

Banks Continue To Support Commercial Properties

Financing is not hard to come by, either. Loans for commercial real estate were at an all-time high of $2.9 trillion as of May 2023, according to the St. Louis Federal Reserve Bank, which has tracked that figure since 2004. In the past year alone, commercial real estate loans have jumped by about 10%.

Banks appear ready to handle a potential economic downturn. The Federal Reserve says all 23 banks that underwent its annual stress testing showed they could withstand a severe recession.

Those institutions hold about 20% of all banks’ office and downtown commercial real estate loans.

The stress test projected a loss rate of “roughly triple the levels reached during the 2008 financial crisis,” according to the Fed. The test results, published on June 28, revealed that “while large banks would experience heavy losses in the hypothetical scenario, they would still be able to continue lending.”

Recession Still Expected; Office Space Most Vulnerable

With or without a commercial real estate crash, many observers still expect a downturn.

Commercial real estate services and investment firm CBRE predicts that Fed interest rate hikes aimed at taming inflation will lead to a recession later this year, which will in turn result in less real estate investment and leasing.

“The drop will be gradual and bumpy,” said CBRE in its latest forecast. “The economy should stabilize by the start of 2024 but the downturn’s impact on real estate will linger until employment growth resumes.”

Banks are already beginning to charge off delinquent commercial real estate loans. The rate of charge-offs indicates the market’s direction because it means borrowers can’t afford the loans. For the first quarter of 2023, the delinquency rate is 0.95%, according to CFRA Research.

That’s below the pre-pandemic level of 1.01% in the first quarter of 2020, but “these ratios are expected to deteriorate further in the second half of 2023 with a weaker U.S. economy,” said Kenneth Leon, a research director at CFRA Research, in a June 20 report. “The office market has weakened since the pandemic.”

The Fate of Office Space Is Unclear as New Buyers Emerge

In the wake of Covid, some employees are returning to the office, but hybrid and remote work are here to stay. Companies such as JPMorgan Chase are directing employees to return to work in person, while others, like Amazon and Apple, are requiring them to be in the office only part of the time.

As a result, “the future of the traditional office space is unclear,” NAR said in an April 2023 report. So property owners are looking for creative ways to repurpose their vacant office space.

The NAR has noted that universities are showing an interest in leasing office space to attract students back to class.

Some office buildings are being turned into apartments or condominiums, though renovations are tricky and inflation has pushed up costs.

Converting office space to housing, Krosby says, doesn’t necessarily fix the problem because demand for those units hinges on employees returning to work, and wanting to live nearby.

Despite the difficulties, some buyers appear willing to step in—albeit at a discount. Even moderate demand could lessen the impact of a recession.

“I’ve had sellers come back to me that I made offers on that said I was crazy 12 months ago who are now entertaining my exact offer,” says Dutch Mendenhall, founder of RAD Diversified REIT. “Six months from now, it will start to be a real optimum time to buy office space.”

Source: “Crash? What Crash? Why Commercial Real Estate Hasn’t Gone Bust…Yet“

Leasing velocity slowed down in commercial real estate during the year’s second quarter. While there is still much uncertainty about the total impact of the bank failures earlier in the year, there are rising concerns and speculation about where commercial real estate is headed. Since commercial real estate relies heavily on small banks for capital, a pullback in lending among these banks could further impact commercial real estate. However, data shows that commercial real estate lending activity is increasing weekly. Meanwhile, delinquency rates for commercial loans have increased since the end of 2022, but they remain below 1%. Nevertheless, delinquencies are expected to rise further in the year’s second half.

As a result, most commercial real estate sectors continue to experience slower rent growth and higher vacancy rates compared to the previous year. In the office sector, there are more available spaces for lease than ever. Despite multiple efforts to repurpose unused office spaces, the slow return-to-office movement continues to hurt this sector. In the multifamily sector, rent growth has slowed even further compared to the beginning of the year, but the vacancy rate remained virtually the same in the second quarter compared to the previous quarter. Although leasing activity continues to slow down in the retail sector, the vacancy rate remains near 4%, the lowest rate in any other sector in commercial real estate. Finally, the performance of the industrial sector has eased from the 2022 record highs, but rent prices for industrial spaces grew more than 8%, significantly faster than pre-pandemic.

Here is how each commercial real estate sector performed in the second quarter of 2023:

Multifamily Properties

With multifamily construction overperforming in the last couple of years, the completion of these additional units has increased the vacancy rate in the multifamily sector. In the meantime, in the last 12 months, net absorption of apartments was half of last year’s level, while 22% more units were delivered during that same timeframe. Thus, this demand-supply mismatch has increased the vacancy rate to 6.9% from 5.3% a year ago. Consequently, rent growth has dropped to 1.1%, below the pre-pandemic level. Nevertheless, the multifamily sector will remain strong compared to the other CRE sectors, owing to favorable demographics, a strong job market, and low housing affordability due to higher mortgage rates.

Office Properties

Even though more people are going to their offices more often, the office sector still faces challenges. The office vacancy rate reached a new record high at 13.1% at the end of the year’s first half. With hybrid work arrangements allowing for a mix of in-person and remote work, a lot of office space is left empty. Meanwhile, in their effort to reduce their occupancy cost, tenants have decreased the average square footage per person leading to lower demand for space. The office sector is transforming to adapt to changing working arrangements and needs.

Industrial Properties

The industrial sector of commercial real estate has slowed down this year from record highs during the pandemic, but it continues to be stronger than the pre-pandemic level. Net absorption was nearly 40% lower at the end of the year’s first half compared to the previous year. But, along with lower demand, significantly more industrial spaces were delivered in the market. As a result, the industrial vacancy rate rose to 4.7% and rent growth eased to 8.9%. However, rents for industrial spaces continue to increase faster than before the pandemic.

Retail Properties

Due to the emergence of e-commerce, the “traditional” retail sector has been challenged over the past decade, with the pandemic decreasing activity even further. However, the retail sector was able to remain stronger than pre-pandemic. The vacancy rate has been unchanged for the last three quarters at 4.2%, the lowest vacancy rate among all the sectors- With inflation easing further and interest rates to stabilize later this year, the demand for retail space is expected to remain robust.

Hotel Properties

Hotel demand advanced even further, increasing occupancy and encouraging higher-priced room rates. The hospitality sector saw a further increase in hotel revenue, which was previously affected by COVID-19 restrictions and quarantine measures. The revenue per available room (RevPAR) is now over 13% higher than it was before the pandemic. As both business and leisure travel pick up, the demand for hospitality spaces is expected to keep increasing throughout 2023.

Source: “July 2023 Commercial Real Estate Market Insights“