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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2012

Facing Mounting Pressure

Lengthy debt restructuring negatively impacts commercial property markets

Facing Mounting Pressure

Commercial property loans that  were originated during the height of the housing boom are coming to maturity this year and for many years to come. In fact, there is a stunning $1.73 trillion of commercial real estate debt maturing between 2012 and 2016, according to data service provider Trepp LLC.
In addition, Trepp estimates that two-thirds of this maturing debt is currently underwater or borderline underwater, while 56 percent of the 2016 maturities are now underwater by more than 10 percent. As many commercial mortgage brokers may be aware, underwater loans that have hit maturity or don’t generate enough cash flow to cover the debt service can’t be refinanced without new equity or lender write-offs.

As struggling properties go through voluntary or involuntary restructurings, they will put other currently financially stable buildings under additional pressure that may force even more projects underwater. This rolling process will create the most stress on properties located in secondary and tertiary markets — and even on properties currently deemed relatively safe and stable. The economic implications of this process are significant for property owners, debt holders and commercial mortgage brokers who are originating new loans.

Submarket scenario

The following submarket hypothetical scenario illustrates this value-erosion progression. Assume that there are three identical fully leased office buildings on the same street, and assume they each have a current market value of $10 million.

  • Building No. 1 was purchased 20 years ago and has a loan balance of $5 million.
  • Building No. 2 was purchased 10 years ago and has a loan balance of $10 million.
  • Building No. 3 was purchased at the peak of the market five years ago and has a loan balance of $15 million.

In having the largest loan, Building No. 3 cannot compete with Buildings No. 1 and No. 2; soon it will not be able to cover its debt-service payments or find new financing upon loan maturity. The owner of Building No. 3 will run out of money and inevitably face either bankruptcy or foreclosure. During this dispute period, it’s unlikely that the owner will make additional capital improvements and probably will defer all but the most pressing maintenance. As a result, tenants will vacate and move to better-maintained buildings that offer lower rents, and the property will end up nearly empty upon final disposition. The lender will then sell it to a new buyer for a minimal price — say, $4 million — as justified by low occupancy and the capital needed for tenant improvements, deferred maintenance and leasing commissions.

The new owners of Building No. 3 now have a competitive advantage over the owners of Building No. 1 and Building No. 2 because they have lower debt-service payments and a lower basis. Building No. 3 can now afford to undercut its competitors and does so, dropping overall submarket rents and attracting tenants from the other buildings.

In a functioning market, rents will drop to the market-clearing price because tenants likely will take advantage of the declining rents that are caused by soaring vacancies. Building No. 2 now must lower its leasing rates to compete with Building No. 3 — putting pressure on its ability to service debt — and ultimately will go through the same restructuring process with the same foreclosure and disposition result. Building No. 2 will then become more competitive than Building No. 3.

Depending on the severity of local market conditions, even Building No. 1, which looked safe at the beginning of this process, may be in jeopardy. In some particularly devastated markets, Building No. 3 may have to go through another restructuring.

Without a large, positive external jolt to the submarket — such as a new, sizeable employer entering the area or the local economy benefiting from a national rebound — this outcome is inevitable. Even such an external jolt, however, may be offset by tenants making more efficient use of their office space, and/or having more employees work from home as purse strings remain tight.

Vulnerable areas

This rolling collateral damage will be felt most significantly in secondary markets like Cincinnati, where the downsizing or departure of some major local employers had devastating effects on the office sector. In addition, cities that have lengthy and convoluted judicial foreclosure processes, like Florida, may suffer a similar fate. Local communities ultimately will continue to suffer as precious resources are channeled to litigation and bankruptcy rather than on boosting property values and encouraging employers to renew leases. Such commitments have profound impacts on local tax revenues and employment rates, as well.

Accelerating the debt-resolution process, even though it can be painful in the short term, ultimately benefits borrowers and lenders, and hence it benefits communities, too. It reduces the time buildings are neglected and tenants are paying rents that do not reflect the true cost of providing the office space.

All indications point to a slow, choppy recovery. In view of weak macroeconomic fundamentals, tidal waves of bad debt will continue to roll over the real estate market. Although the credit markets have recovered somewhat, there still is limited capacity and an inherent wariness of lenders to make new loans. Commercial mortgage-backed securities issuance has only modestly recovered and commercial banks continue to be overexposed to commercial loans as they work through their enormous real estate owned portfolios. Credit, therefore, likely will remain tight, particularly in secondary and tertiary markets.

• • • 

The bottom line is that commercial mortgage brokers should realize that borrowers and lenders alike should be more efficient in resolving their differences and should be cognizant of the collateral damage they inflict on other properties — and perhaps much more severely, on their communities.

A protracted debt-resolution process is not beneficial for anyone. Lenders must develop a better process for quantifying the costs associated with litigation and bankruptcy, and borrowers should carefully research and clearly understand their lender leverage. Both parties should be realistic about what constitutes an acceptable resolution and exchange information early to resolve disputes on an economic basis. 

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