Navigating the Surge in CRE Distress: Opportunities Amidst Troubled Loans and Foreclosures
The commercial real estate (CRE) market is bracing for a record number of maturing loans and a surge in defaults. Property owners that have balloon repayment loans coming due are struggling to refinance at today’s higher rates. This is “forcing” borrowers to either: inject new equity, raise preferred equity to bridge a new loan, or negotiate a loan workout. If those options aren’t possible, borrowers face selling the asset or foreclosure by the lender. Over the past 24 months, banks’ delinquent CRE loans (construction and shorter-term bridge loans) have steadily increased. This is partly due to the Fed’s decision to keep rates higher for longer. Another factor can be attributed to costs for materials and labor, stagnant rental rates, and increasing operating costs.
Were We Are Now
The Mortgage Bankers Association (MBA) reported that, in Q1 2024, outstanding commercial mortgage debt grew despite slow originations and fewer loans being paid off or refinanced. This resulted in more debt on lender balance sheets and financial risk in the market. Rates are high and borrowers are struggling with increased costs, including soaring property insurance and lower cash flows. Other macro factors contributing to sector distress include the closure of certain retail store segments. Examples include Walgreens, Party City, CVS, and 99 Cents. Also, notable chains like Rite Aid, Family Dollar, and Conn’s have gone bankrupt.
U.S. commercial property foreclosures hit $20.55 billion in Q2 2024. This is a 13% increase from Q1 and the highest total since 2015, according to MSCI.
Furthermore, stagnant or declining rental income within certain markets has placed additional pressure on property owners’ cash flows. Some borrowers have encountered severe difficulty in keeping up with existing debt service payments. In these circumstances, the re-underwritten loan amounts are far less than the balance due for current booked loan balances. Options remain available for high-quality assets and sponsors who can get creative.
Multifamily distress surges 185%
Distress within the multifamily sector has soared 185% this year alone, as reported by CRED iQ. The uptick in delinquencies and special servicing among multifamily CMBS (commercial mortgage-backed securities) loans nearly tripled since January 2024, raising concerns about the multifamily space. As of June 2024, approximately 7.4% of multifamily CMBS loans were either delinquent or in special servicing, a dramatic rise from 3% at the start of the year. This trend puts the multifamily sector near distress levels not observed since 2007.
The multifamily sector’s predicament is partly attributable to a confluence of factors. Rising operational costs have squeezed apartment building owners’ ability to increase cash flow to pay off debt. These include insurance and utilities, rental increase “caps” (legislated in California and other municipalities), and higher refinancing rates. Approximately 78.4% of CMBS loan collateral properties have reported lower net operating income (NOI) than their underwritten NOI at origination. This has put many of these loans in “default,” due to properties not achieving the required minimum debt service coverage for a certain period. With $113 billion in multifamily CMBS debt maturing over the next two years (35% of the total volume of maturing debt), borrowers are facing a “hydrogen bomb scenario,” as described by Peter Sotoloff, former managing partner at Mack Real Estate Credit Strategies.
To compare, the office sector will see $42.3B in debt set to mature over the same two-year period. As of July 2024, the delinquency rate on CMBS loans for office properties has moved from under 2% in 2022 to over 8%. This is the highest delinquency rate seen since 2013.
Where the rest of the market stands
The CMBS delinquency rate ticked up to 5.43% in July 2024, an 8% increase, according to Trepp CMBS Research. To compare, the all-time high on record was 10.34% in July 2012, and the COVID-19 high was 10.32% in June 2020. Year-over-year, the overall CMBS delinquency rate is up 102 basis points. The increase was primarily driven by the office sector, which accounted for two-thirds of newly delinquent loans in July. On the other hand, retail and hotels saw a decline in delinquency rates.
CRE distress rates reached 10.3% in July, a 60-basis-point increase since the CRED iQ report in June. The retail and office sectors continue to produce the highest distress rates, 11.7% and 11.5%, respectively. The hotel sector held on to third place with an 8.1% distress rate. It had the best month-over-month improvement of the group, shaving 130 basis points from June. Self-storage and industrial have maintained significantly lower distress rates at 0.1% and 1%.
The Facts
The refinancing environment is particularly challenging for borrowers. Many can’t bridge the gap between their current debts and the amounts that can be re-underwritten. The Fed held the Fed Funds rate near zero for 10 years. This era of low borrowing rates fueled small and midsized regional banks to lend excessively, which borrowers were more than happy to receive. However, now that these low interest loans are coming due, Fitch and Morningstar have flagged this high volume of maturing debt as a major concern.
Developers are facing the brunt of higher rates, capital calls, and foreclosure. And, unless the Federal Reserve pivots over the coming quarters, these challenges will continue for developers. It’s highly anticipated that a Fed Funds Rate cut will occur in September. However, the question remains by how much and by the frequency going forward. That answer will depend on various factors; including inflation targets (mandates), wage growth, liquidity stress, and most importantly unemployment and jobless claims.
Lending Limitations
Regional banks and money center institutions have significantly pulled back on construction and bridge financing. Instead they are offering support primarily to long-time clients with established depository relationships at lower loan-to-cost thresholds (50%-65% LTC). Private capital parties have stepped in to fill the void. However, they charge higher rates (10% to 15%). They can achieve higher LTC thresholds (65% to 90%) pending certain property, sponsor, and credit factors.
On the permanent debt side, life insurance companies and agencies like Freddie Mac, Fannie Mae, HUD, and even CMBS shops have increased their presence in the market. Their underwriting thresholds have also risen significantly. They use minimum debt yields (8% to 12%, pending the asset class), lower loan to value ratios (50% to 75%), and higher debt service coverage ratios (1.25x to 1.40x) using a 25 or 30-year amortization schedule.
Regional Bank Problems
In parallel, regional banks are grappling with CRE loan distress. Contrary to previous assumptions that smaller banks were the primary culprits. A recent S&P Global Market Intelligence report reveals that while smaller banks have a higher concentration of CRE loans, regional banks are encountering significant risk in their CRE portfolios. Delinquencies and net charge-offs on non-owner-occupied properties are notably higher among these large institutions. This growing risk has even led Moody’s to review several large banks for potential credit downgrades. And more market downgrades are expected in the coming quarters.
While the tightening of capital availability presents challenges, it also creates opportunities. As regional banks seek to offload bad loans and reduce their CRE exposure, savvy investors will find attractive acquisition prospects. These assets can be financed through alternative sources such as life insurance companies, private bridge lending sources, CMBS shops, credit unions, preferred equity partners, and a combination thereof. This evolving landscape offers major potential for well-capitalized investors to strategically acquire distressed assets at a lower cost basis and capitalize on the shifting market dynamics.
Options for Borrowers
Looking ahead, the outlook for market liquidity will be constrained. This is particularly true for regional banks until their loan books can be cleaned up. This underscores the importance of borrowers to explore a diverse stable of capital sources beyond traditional banks.
For those in the multifamily market facing refinancing challenges, several strategies can be considered:
- Rate buy-down: Some borrowers may negotiate a rate buy-down, paying points upfront to lower their interest rates and maximize loan proceeds and interest only options.
- Short-term bridge loans: An interest-only bridge loan can provide temporary relief while waiting for interest rates to decline (12 to 36 months).
- Equity injection: Infusing new equity into a project will reduce the loan balance to meet current underwriting thresholds and keep the cost of capital relatively low until rates come in.
- Preferred equity: Bringing in preferred equity can bridge the gap between the existing debt and a new loan (bridge or other); however, this will require relinquishing a share of ownership in the asset.
- Asset sale: Selling the asset remains a viable option.
Outlook
As the multifamily sector and broader CRE market continue to navigate these turbulent times, strategic capital management and adaptive financial strategies are crucial. With a volatile economic landscape and a wave of maturing debt on the horizon, stakeholders across the industry will need to carefully manage their exposure and prepare for potential shifts in market conditions. For those who have a loan coming due in over the next 12 months, it’s encouraged to reach out to a Capital Markets professional. They will be able to assist in tracking monthly cash flows, interest rates, and changing in lending underwriting with various capital sources.
Be prepared to take advantage if and when rates come in. We may be on the cusp of seeing lower rates as Treasury Yields have dropped recently due to the recent stock market correction (August 8th). In addition, spreads for Freddie and Fannie loan quotes have decreased slightly due to the lack of mandated loan volumes, although “mission based” business represents the lowest pricing in the multifamily market today along with 35-year amortization schedules. The key going forward is staying engaged with your Capital Markets Advisor for recent updates as the market changes as volatility increases over the end of the year.
