The Show Starts?
“Nearly $1.5 trillion in commercial mortgages are coming due over the next three years, according to data provider Trepp. Many of the commercial landlords on the hook for the loans are vulnerable to default in part because of the way their loans were structured”.
While most home mortgages have a payment process which includes both interest and some principal, many commercial loans are IO (Interest Only) loans where they haven’t had to pay down any of the original loan amount.
According to Trepp, “Interest-only loans as a share of new commercial MBS issuance increased 88% in 2021, up from 51% in 2013”.
When commercial real estate prices were rising as cap rates declined pre-2021, it was easy to finance and re-finance your loans. Money was cheap, plentiful, and lending standards were easy.
Now with impaired balance sheets, banks are having to look at their underwriting standards for new loans and at the same time deal with negotiations (if there are any – some borrowers are just walking) with their borrowers. It’s not a pretty picture.
It’s not surprising that the IO market exploded. As we left the deep recession in 2007-2008 (I refuse to call it the “Great Financial Crisis”), rates declined dramatically and when the property market started to recover, banks were now flush with cash and incentivized to get it out in the market.
Look at the stunning increase in supply of CRE’s from 2009 to 2020. From around $1.4 in 2012 to over $2.8 today.
Spreads will likely widen dramatically given the recent yield curve and Fed’s policy on inflation. Money will be even more expensive than the traditional spreads we have seen.
It’s mind boggling that the credit issued between 2012 and 2016 was done at such low rates, encouraged by the Fed and Treasury. Now on a normalized, or at a minimum “get ready for the shit to hit the fan” moment, investors can’t afford to rollover their loans at prime plus 5-7 or so. Their deals make no economic sense.
They will consider themselves extremely lucky or smart to have re-financed any of their properties in 2015 to 2017 and taken out some or all the bait they had in the water. This was and will continue to be, absent tax changes, a way to deleverage the investors capital in deals by the return of capital on the re-fi’s to them. Going forward, I think it will be very difficult to get done in the next year or so except via private credit or mezzanine lending.
The WSJ had another article which gave a good background of how the office glut started well before 2014 or so because of changes in tax policy. It’s worth a short read.
America’s Office Glut Started Decades Before Pandemic - WSJ
Tax incentives led to overbuilding anyway. Tax policy can have some serious, negative side effects. Besides the depreciation changes, quicker deductions that were available from the Tax Reform Act of 1986, landholders also benefited greatly from Code Section 1031 like-kind exchanges. They almost got a re-do (exchange of 1st property), and 2nd, 3rd drink from the fountain of easy money.
What does this mean in the short term?
Cotton isn’t down to a quarter pound but there are a lot of busted commercial property owners and their bankers. Unfortunately, in the same way that Ray Charles brother can’t help him, these property owners aren’t going to have friends that can help them. They should expect default scenario’s, predatory lenders, smart private equity money and maybe, if they are really lucky – a counter party bank that can’t write down the loan. IE Pray and Extend.
Medium Term:
1) Price discovery of the assets. It’s going to be a price discovery based upon location, usage and from balance sheet/lending side and whether there were other tranches of debt on the property.
2) Balance sheet discovery. A lot of people who looked extremely rich from an evaluation of their real estate holdings will suddenly not look so well off. If they didn’t shelter some assets (asset protection) or were foolish enough to give personal guarantees on the properties, they are way upside down. My instinct is that a lot of the experienced investors who have been through a couple of cycles are fine, and this is merely a disruption to them. It’s the bank’s problem. For the people who entered the market coming off the lows, it’s going to be a bell ringing wake up call.
3) New Build:
a. Owners: It is going to be much harder for smaller businesses to finance their properties, if they want to build or need to build. This is especially true for niche manufacturing businesses who need specific set ups, but it also extends to someone who wants to own the ground under their shop.
b. Renters: They should see better pricing. But maybe, on the Residential side, the lower rent might be offset by higher HOA fees if the landlord hasn’t maintained the properties, which is often the case in these situations.
4) General wide-spread market disruption in the office space market
Benefits/Results?
Great for local investors who understand their demographics and have capital to invest for the long term.
Great for Large, distressed PE focused firms.
Great for the workout groups of law firms (it’s been so long since they had to work).
Maybe a continued increase trend to desire to work from home or in more rural, easier access places. Who wants the hassle of traveling to a big empty building?
Severe decline in city tax rates
Remote work and ecommerce effects are underway – it is just a question of how bad it will be.
Potential Good:
Repurposing office space to residential housing which a lot of cities need – affordable housing.
More green space? There’s an argument to be made that in certain instances, some of the older buildings which will go under are better off razed and used for green or community space. This has been done in other cities. It isn’t sensible from a tax point of view of the city as it loses the tax revenues, but it provides other benefits.
A story we have seen before:
*Equity holder gets wiped out – could be mom and pop or just a moderately successful family grinding it out. Caveat emptor.
*On the banking side:
They will have to go back to their history/bank fundamentals books and create some relatively smart workout teams – and fast. It has been a while since work out teams had to really sharpen their pencils.
Credit departments will do whatever they can in terms of mitigating a full auction/distressed sale. This means that banks will have to restructure their loans or sell off at best price via auction or private sales. Either way, impairment on balance sheet and negative earnings.
We will likely see a political/governmental push for higher capital standards on banks pulling things back to what they used to be. Continuation of the lack of liquidity for the space.
*It will create a very interesting opportunity for new capital: whether it’s providing direct senior lending, new capital and ownership in the projects or direct acquisition from sellers/banks.