$1.5 trillion debt signals trouble for commercial real estate market

By Doug Bailey

Powerful headwinds pounding the commercial real estate market could signal an impending economic catastrophe – complete with bank failures, massive defaults, and collapsing valuations – or just some rough sailing ahead, depending on whom you talk to.

There’s no debate about the troubling signs. Almost $1.5 trillion of U.S. commercial real estate debt comes due for repayment by 2025 while the number of banks willing to refinance is severely shrinking. Estimates that property valuations could fall more than 40% have some analysts predicting that more than 200 banks are on the precipice of repeating what happened to Silicon Valley Bank. The remote working trend kicked off by the Covid-19 pandemic has reduced occupancy and slashed demand with tenants unable to pay rent, leaving landlords facing decline property values, defaults on leases and plummeting income.

“The question isn't whether commercial real estate is going to crash; it's when, where, and how badly.”Leonard Ang, CEO of iPropertyManagement.com

“The question isn't whether commercial real estate is going to crash; it's when, where, and how badly,” said Leonard Ang, CEO of iPropertyManagement.com, an online resource for landlords, tenants and real estate investors based in Birmingham, Alabama. “The Fed can keep banks afloat if they're too heavy on these kinds of assets, but that doesn't do anything for the assets themselves.”

Ang recommends property owners focus on alternative occupants for their empty spaces as a way to stave off defaults and plunging values.

“Housing, schools, childcare centers, and server farms could all make good use of these spaces, depending on renovation costs and local zoning codes,” he said.

Zoning reform may be a recovery path

Others believe that zoning reform might be a path toward recovery for the commercial real estate market.

“In my view, the driving factor behind any commercial real estate turnaround depends on the willingness of each state governor, local mayor, and city or county council to modernize outdated codes for zoning, design, mixed-use, affordable housing, and even height restrictions,” said Baron Christopher Hanson, statewide off-market commercial property specialist at RT Commercial Real Estate in Port Lucie, Florida. “It's 2023, not 1963, and the future of commercial real estate success post-COVID will require a completely different matrix of architectural design, materials usage, and human and commercial utility based on more modern and uniform codes.”

Such reforms are likely to evolve slowly, though, while economic conditions could worsen in the meantime.

Banks, lenders 'more risk averse'

“Banks and lenders have become much more risk averse, and borrowers are finding fewer options, almost of all which are significantly more costly,” said David Sussman, CEO of Valcor Worldwide, a Vancouver-based debt restructuring and small business consultant. “We are seeing many lending deals fall apart at the 11th hour, pushing borrowers into highly dubious loan vehicles like Merchant Cash Advances, which, in our opinion, should be illegal. These types of loans lead to widespread default judgments, business failures, and even suicide.”

Sussman predicts a dramatic devaluation in multiple property categories including office, medical, industrial, retail, strip malls, and others.

“Unfortunately, we believe this will get worse before it gets better,” he said.

Commercial real estate market refinancing risks

James Eagan, an analyst for Morgan Stanley wrote last week that refinancing risks are “front and center” for property owners. Banks, the analyst noted, own more than half of the commercial mortgage-backed securities, which increases their exposure to the commercial real estate sector.

“The role that banks have played in this ecosystem, not only as lenders but also as buyers will compound the wave of refinancing coming due,” the Morgan Stanley note said.

Prospective buyers in the commercial real estate market need more cash flow to pay the higher debt service and sellers are not yet willing to accept lower prices, said Ronald Max, strategic real estate investment advisor at Real Estate Bees, in Chicago.

“It remains to be seen how commercial real estate will fare with higher interest rates that in some cases are now double what they were 5 or 10 years ago,” he said. “Can properties find ways to refinance when those low interest rates come due? Hopefully those old loans amortized down sufficiently will allow them to be refinanced. If not, this could result in another big wave of foreclosures.”

The inability to fairly assess values in this market environment is discouraging investors, some say.

Fed rate increases cited

“The Fed hasn’t yet stopped raising rates, which makes it hard to value what property should be,” said Ankush Israni, a partner in Stroock & Stroock & Lavan, in Los Angeles. “Sellers are still living in 2020, not willing to reduce their properties. Everyone wants to talk value, but it’s hard to determine value with people on the sidelines waiting for the Fed to stop raising rates. No one knows what the ceiling is so they can’t value properties effectively.”

Israni, however, says there is still a lot of capital in the system, waiting to be deployed, unlike in other downturns.

“It will be interesting to see if it will be similar to Covid’s first six months,” he said. “After restrictions lifted, the market was swamped and snapped back quickly. That may happen when inflation levels off. Until then, we still see transactions happen, just a lot slower.”

Others, too, think there is some light if the Fed stops raising interest rates and vacancy rates improve.

“It is important to note that the market has historically been cyclical and has demonstrated resilience in the face of adversity,” said Matthew Sanchez, founder and realtor team lead of Gator Rated, a real-estate association in Florida. “However, there may be some legitimate concerns about the possibility of a larger crisis if banks continue to restrict lending and vacancy rates remain high. However, keep in mind that the Federal Reserve has stated that banks remain strong and resilient, which may provide some reassurance to investors.”

Doug Bailey is a journalist and freelance writer who lives outside of Boston. He can be reached at [email protected].