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Many investors have hit the pause button for new commercial real estate projects. The increased cost of borrowing resulting from the steady rise in interest rates, combined with more conservative lending terms, has caused a significant drop in activity. In the last week of June, commercial and industrial loans fell by $7.9 billion to $2.75 trillion, after having peaked at $2.82 trillion in mid-March. Current owners, however, have little option but to face the challenges associated with refinancing loans coming due under less-than-favorable conditions. To assist small- to mid-sized investor clients, consider these insights from brokers, investors and lenders on weathering today’s commercial lending environment.
CRE Loan Snapshot
Analysis from Morgan Stanley Capital International found that nearly $900 billion in U.S. commercial property loans will mature in 2023 and 2024. MSCI analysts project almost $1.5 trillion of U.S. commercial real estate debt will come due before the end of 2025. In addition to higher borrowing costs, depending on the asset class, clients who hold these loans may also face lower valuations, softening rents, a smaller pool of lenders, tighter lending policies and increased scrutiny from risk-averse lenders concerned with balancing their loan portfolios.
“It’s a tsunami for owners who are not on top of it,” says John LeTourneau, CIPS, RENE, commercial managing director for Keller Williams in Naperville, Ill. “My team has been making the debt call for two-and-a-half years to let owners know their property will refinance in ‘X’ years and to expect their debt to be adjusted upward.”
New investors may be shocked by the current lending environment, especially if they haven’t raised rents. “The primary hurdle used to be loan-to-value ratio because debt was so inexpensive,” says LeTourneau. “Now, it’s the other way around—debt-service coverage ratio—and people will need to recapitalize.”
“We keep our reserves on hand in case properties don’t appraise at their previous debt-service coverage rate,” says Michael Quigg, president of St. John Holdings Inc. in Radnor, Penn. “Right now, for office, it’s a double whammy with occupancy down and rates up,” says Quigg. “We’re seeing loan rate numbers up 200 basis points from the original loan.
“There are product types we wouldn’t look at right now—primarily office—because lenders are scared to make loans,” Quigg adds. “We might find a nice property at a good price with long-term tenant leases but pass on it because of the difficulty of financing. Many tenants want to downsize, and banks are getting hammered by regulators for having too much office in their loan portfolio.”
Inject Capital and Reduce Costs
Dawn Aspaas, broker-owner of Complete Real Estate in Sioux Falls, S.D., is advising her small investor clients to review their portfolios and identify potential weaknesses. “You need to be sure the portfolio is balanced, tenants are secure, and leases are locked in,” says Aspaas. “Otherwise, you may find yourself upside-down.”
Aspaas warns of rising utility costs such as water and sewer rates that catch building owners by surprise. While utilities typically rise with inflation, municipalities renewing contracts that have expired after three or more years are seeing double- and triple-digit increases in some instances.
When a property fails to appraise at the necessary debt-service coverage ratio, owners typically inject capital or work with the lender to restructure or write down the loan. Investors with a diverse portfolio are more likely to manage by moving projects and money around and, where possible, get the bank out of the picture, according to Aspaas. A small investor, however, has fewer good options.
LeTourneau helps his clients prepare by identifying opportunities to increase revenue and, in his words, crush expenses. “There are many ways to make buildings more efficient,” he says, such as low-flow water fixtures and LED lighting. He also encourages owners to explore green incentives available through local utilities. Owners with just one or two properties can save costs by taking on basic maintenance or janitorial work.
Be Honest With Your Lender
Being transparent with the lender is critical in today’s market. “Lenders want that conversation,” says LeTourneau, “because they don’t want a negative asset on their book.”
Natalie Falatek, regional president of Mid Penn Bank in Harrisburg, Penn., agrees. “We want to know everything about a deal—warts and all,” says Falatek, who adds that it’s not uncommon for a loan application to get denied at the last minute in committee because someone found some obscure information online that wasn’t disclosed.
“The biggest lending challenge we’re seeing right now is that when you do a two- to three-year look back, you’re hitting the pandemic time where there was a hiccup in business financials,” she says. “The higher rates have severely impacted our smaller borrowers, but if they position things right, they can come out in a better financial position.”
Falatek says brokers can help clients by establishing relationships with banks to learn lenders’ appetites for various asset classes and find the right fit. “We encourage borrowers to establish a banking relationship and get to know us while we get to know them,” she says. “Knowing our customers and how they make money is the best way to counter uncertain economic conditions.”
Fitting the Solution to the Loan
With the number of troubled assets on the rise, borrowers and lenders are getting creative. Banks use various strategies to help owners and investors restructure refinance in the current lending environment, including loan extensions, interest-only periods, bridge loans, U.S. Small Business Administration enhancement or guarantees (where qualified), A/B loan structures and swap programs to protect against fluctuations in interest rates.
Not all strategies are a good fit for all loan scenarios. Best-fit solutions vary depending on the circumstances and whether it is a recourse or a non-recourse loan, which allows a lender to seize only the collateral specified in the loan agreement, even if its value is insufficient to cover the debt. Some of these strategies are quite complex, and new or inexperienced borrowers can find themselves in a worse financial state if a lender approves a loan that, over the long term, isn’t a good fit.
With the number of troubled assets on the rise, borrowers and lenders are getting creative.
Colleen Ensinger, senior vice president for Mid Penn Bank, advocates for community banks where borrowers and their broker can establish a personal relationship with their lender. “We look at both the customer and the transaction to determine the right loan structure,” she says, citing an example where a longer interest-only period might be right for owners who can’t raise rents immediately. “If they ask for something that’s not good for them, we’ll tell them. Big banks will support big customers, but, in my experience, smaller customers don’t get that level of service” from them.
When Banks Won’t Lend
As banks become more conservative in their lending, investors are turning elsewhere for sources of capital. “We would look at nonconventional lenders, such as a private credit company or a real estate hedge fund,” Quigg says. “They don’t operate under the same regulatory environment as banks. While their rates are likely higher than banks, they are an option if you can’t get a conventional load.”
Other bank alternatives include life insurance companies and private debt funds, also called credit funds or fixed-income funds, in which the core holdings are fixed-income assets. As banks pull back from lending, debt funds play a larger role.
Market Opportunities
Not everyone views the current market as a challenge. Buyers sitting on a lot of cash see it as an opportunity. “Speculative investors can come in and purchase properties from banks for pennies on the dollar,” says Aspaas. There are opportunities even for those without large cash reserves, including in the office sector, which is attracting the greatest scrutiny. “We always leave a little space in the office bucket,” Ensinger says. “For someone with good credit, we can look beyond just the numbers.”
In May, the Mortgage Bankers Association projected commercial and multifamily mortgage borrowing and lending to decline by $654 billion in 2023, a 20% drop from 2022, but to bounce back in 2024 to $829 billion. “We expect maturing loans to begin to break the logjam and provide greater clarity as this year goes on,” says Jamie Woodwell, head of commercial real estate research for the MBA. “However, it may take until 2025 for volumes to get back to previous years’ levels.”
In the meantime, brokers can continue to support their investor clients’ interests. Quigg looks for the broker to anticipate objections from lenders and have ready responses. “I understand the bank’s position,” Quigg says. “We look at the same factors lenders look at for a new investment, but a good broker can counter most objections.”
