Tightening Credit Conditions and an Ongoing Liquidity Crunch Intensifies Challenges in US Commercial Real Estate
As of late 2023, the US commercial real estate (CRE) market is grappling with a deepening liquidity crisis. Private lenders, who have become the primary source of funding due to soaring interest rates, are becoming increasingly cautious. This shift is exacerbating the liquidity crunch in an industry already strained by a massive wave of debt coming due.
Banks have been renegotiating CRE debt terms to prevent defaults, necessitating additional equity from borrowers. This has opened doors for private financiers to step in with alternative financing solutions like mezzanine loans, preferred equity, or new common equity. Initially, these restructurings were concentrated in the office space sector but have now expanded to include multi-family residences, industrial properties, and hotels.
Lower Rental Incomes
As rental incomes fail to keep pace with rising debt service costs, even private lenders are finding the numbers hard to justify, according to industry insiders.
Mike Comparato, president of Franklin BSP Realty Trust, notes that while debt is still accessible, it’s significantly more limited and costly, leaving property owners with few, if any, attractive options.
The CRE borrowing landscape has been altered by the sharpest increase in interest rates in years, compounded by stricter lending criteria following regional bank collapses in March and a decline in office space usage in the post-pandemic era.
Jeff Holzmann, COO of RREAF Holdings, acknowledges that it’s an opportune moment for private lenders, but also recognizes that not all deals are beneficial, especially in cities facing market decline due to rising crime and demographic shifts. Some properties may not recover even with lower interest rates, particularly those requiring substantial investments for rehabilitation, which can diminish returns.
The growing caution among private lenders is set to further exacerbate the shortage of liquidity for property owners who are finding themselves without viable exit strategies. Industry experts highlight that interest rate caps, which previously offered protection against rate hikes, are expiring soon, and the cost to renew them has skyrocketed from thousands to millions of dollars.
As property values decline due to weaker market fundamentals, borrowers are qualifying for smaller senior refinancing loans at rates that are significantly higher, sometimes by 500 basis points or more.
Refinance at any cost?
Razmig Boladian, co-managing partner at Rubicon Point Partners, points out the dilemma facing office property owners who are pressured to refinance at any rate but are unable to meet loan repayments, while lenders lack the balance sheet strength to provide loans.
The market is currently experiencing severe liquidity constraints, creating a standstill situation. Even with a substantial drop in the value of vacant buildings, there’s no assurance of generating returns that would justify the investment, Boladian adds.
Selling assets is also proving difficult, with either a lack of buyers or only a few who are willing to purchase at such low valuations that sellers may walk away with nothing after clearing their debts, according to Claudia Faust, co-founder and managing partner at Hawkeye Partners. Prospective conversions are on the horizon, but could prove costly, with some estimates as high as $500 per square foot.
Looming Maturities Cloud the Landscape
The looming maturity of nearly $2 trillion in CRE debt over the next two years is expected to heighten the demand for private financing.
Alex Horn, the managing partner at BridgeInvest, a private commercial real estate mortgage lender, noted a significant decrease in the number of lenders in the market. He observed that while last year they would typically see competition from 5 to 10 lenders for a new quote, this year they are often the sole lender making an offer.
BridgeInvest is poised to process loan applications totaling $40 billion in 2023, a substantial increase from just over $20 billion the previous year. However, Horn mentioned that only about 2% of these applications might result in loans, as some applicants are over-leveraged and may face challenges in managing their debt payments.
Jay Hiemenz, president and COO of Alliance Residential, suggests that depending on the sector, it might take over three years to enter a recovery phase. He also mentions the risk for private lenders who may need to downsize their portfolios, which are costly to maintain.
The delinquency rate for loans in commercial mortgage-backed securities currently stands at 4.76% but is projected to reach 10.51% in the coming years, a peak last seen during the global financial crisis, as per Moody’s Analytics.
However, Thomas LaSalvia, head of commercial real estate economics at Moody’s, believes that while the market will likely see a purge of the surplus of assets that are no longer viable, there is insufficient evidence to suggest a systemic crisis.