Consequences of Looming CRE Debt Maturity

SAN FRANCISCO-While there are many encouraging signs of recovery in the commercial real estate market ranging from rising property values to increasing mortgage originations, investors should be aware that there is also a great deal of CRE debt set to reach maturity in the next several years.

At the end of 2012, outstanding CRE debt was estimated to total $3.6 trillion, a great deal of which represents borrowing that took place at the height of the market before the financial crisis when CRE values were rising and vacancy rates were falling. Now, about 10% of that total—approximately $350-billion—is set to come due each year between 2012 and 2017.

What are the implications of the coming scheduled maturities for repayment of those loans and for those borrowers who will need to refinance maturing loan? Under these circumstances, the combination of rising interest rates, an economic recovery stuck in slow motion, and increased caution among lenders could create a scenario leading to a rash of borrowers defaulting on their loans at maturity. Furthermore, as interest rates rise in the coming years, marginal properties with high leverage relative to current lending standards will see a higher rate of default.

The field of restructuring CRE debt is as much art as it is science. The best approach for resolving distressed loans is to create a customized solution to each unique situation which addresses all aspects of the underlying asset and the borrower including the borrower's financial condition.  The relative strengths of the local market must also be taken into account. 

Over the past couple of years, the national real estate recovery has been uneven varying greatly between regions.  The value of coastal properties and trophy buildings has risen, giving many investors the option to refinance or sell at a profit. Unfortunately, that option is largely unavailable to those with properties located in many inland markets or to secondary properties. There is also a great deal of variation the health of different property types.  Asset classes that are out of favor or those that remain oversupplied will continue to be difficult to finance and may therefore be candidates for foreclosure or distressed sales. For instance, CoStar reports that sales of distressed retail properties were up 4% in 2012. 

There is also a great deal of diversity when it comes to the financial health of borrowers.  Increasingly, borrowers are becoming healthier; however, there is still a large percentage of borrowers that remain under some level of distress ranging from mild financial weakness to classic candidates for bankruptcy. The health of the borrower can be as important to the success of a workout situation as is the strength of the underlying property.

In what is expected to be a rising interest rate environment in the coming years, a customized approach to debt restructuring distressed loan is critical. It is also vital to take a proactive approach and engage the lender early in the process and well in advance of the maturity date, if full repayment is not possible.  Maintaining complete transparency with lenders from the outset is another key piece to a successful resolution, because a foundation of trust is established which will build positive momentum in the negotiation with the lender.  Finally, it is important to understand the situation from the lenders' perspective.  A perspective that a team member experienced in loan restructuring can bring to the situation.

Lenders are as diverse as borrowers in terms of their financial condition and motivations. While banks with strong balance sheets are more likely to keep bad loans on the books waiting for further recovery, others may write-off bad loans with a discounted payoff or sell the note on the secondary market, an increasingly common method of resolving defaulted loans.  CMBS special servicers have different perspectives from conventional banks and different methods for resolving troubled loans.

The lender's attitude toward each situation can also vary depending on the financial strength of the borrower and the actions taken by the borrower as the loan becomes distressed.  If the information flow to the lender has slowed or the borrower becomes less forthright in the lender's view, for example, the lender can quickly become wary and decide not to work with a borrower.  On the other hand, if a borrower shows willingness and an ability to put new capital into a property or raise additional funds, then the lender is also more likely to be cooperative in an inclusive resolution that will be to the borrower's advantage.

By understanding lender motivations and the nature of the information important to a lender before a negotiation starts, it is possible to approach the lender in a proactive manner and preserve alternatives which would otherwise be lost if the borrower waits for the lender to take the initiative.  The implications can be significant resulting in the difference between keeping a property with a modified loan and losing a property to foreclosure, for example.

Some borrowers have limited options due to the amount of leverage with the current market value of the underlying property coupled with a weakened financial position of the borrower.  Without considerable financial assets a borrower may face foreclosure or a distressed sale. In these cases, depending on recourse, it may be in the best interest of the borrower to proactively approach the lender and pursue a deed-in-lieu of foreclosure and to begin negotiating a settlement of the subsequent deficiency if appropriate.

The coming wave of maturity defaults could be reduced under certain circumstances such as continued low interest rates, an unexpected surge in the economic recovery, or an unanticipated loosening in lending standards.  However, the maturity defaults that will invariably come can be resolved in a more favorable manner to both borrower and lender with a proactive approach that includes a team of experienced financial and legal resources.

Mark Richardson is a principal with Huntley, Mullaney, Spargo & Sullivan, Inc., a debt and financial restructuring firm. He can be reached at mrichardson@hmsinc.net or (415) 677-9627. The views expressed in this column are the author's own.