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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2015

Avoid the Road to Distress

Looming problems could cause an unfortunate repeat of history

Avoid the Road to Distress

Commercial real estate is headed down a familiar path. Sure, the landscape is lush. Cities are booming, almost all key metrics are headed in the right direction, and the problems that the industry encountered during the recession are all in the rearview mirror. The forecast seems to be bright and sunny.

Well, almost. Some dark clouds loom on the horizon. Turn around, and the clouds look the same, far off in the distance.

Although the current commercial real estate market looks bright and promising, there are some distressing signs for the future. These signs are nearly identical to the ones that caused so many problems earlier in the 2000s — and without taking action, the industry may be headed down a dangerous path.

When many people think of a distressed property, their mind conjures up the image of a vacant building with weeds growing on the outside and boarded-up windows — all clear signs of neglect. The images of the Great Recession, complete with squatters and code violations, are still fresh. For investors, however, it is often the sign of a great investment opportunity.

During the recession, major metropolitan areas had many buildings that looked just like the one described above; vacant and lifeless, with weeds growing outside. It was an easy time to see visible signs that the economy was in a state of distress. The commercial real estate market was also in a steep downturn and delinquencies were high.

Today, if you drive through those same major metropolitan areas, you will see a much different view. Cities are bustling, there’s little vacancy. Sometimes you see new construction, and you see little evidence of the previous distress. It is easy to be lulled into a false sense of confidence and comfort that all problems are behind us and happy days are here to stay.

But are they?

What if there was a sudden earthquake that destroyed the cities? Not the visible kind, but something akin to one lurking just beneath the surface.

A familiar problem

A big fault line exists right now among our beautiful scenery of performing commercial real estate — overleveraged, maturing loans, specifically in the arena. Why? Because the commercial mortgage-backed securities (CMBS) loans made from 2005 to 2007 were initiated with loose underwriting standards. Considering the state of the market during that period, this isn’t particularly surprising.

If this sounds familiar, it’s because it is. These are the same type of problems that were endemic to setting up the eventual residential housing market crisis. Consider these eerily similar factors that contributed to those initial problems:

  • Little to no reserve requirements for commercial property buyers — equivalent to a residential owner’s net worth and ability to withstand a crisis
  • Low debt-coverage ratios for CMBS loans — equivalent to ignoring a residential buyer’s ability to repay
  • High loan-to-value (LTVs) ratios — equivalent to the same in the residential market

Distress on the doorstep

With the vast majority of these loans having 10-year maturities with interest-only payments, distress is back on our doorstep, and it won’t come quietly. Some crucial facts back up this statement.

According to data reported by Morningstar in this past February, and later analyzed by a third party, 30 percent of the $86.9 billion of CMBS debt  ($26.1 billion) maturing in 2015 is not expected to be able to refinance at maturity. In 2016, that number increases to 44 percent of the approximated $128 billion of CMBS debt ($56.3 billion) maturing, which is not expected to be able to refinance at maturity. In 2017, a staggering 51 percent of the $124 billion  of CMBS loans ($63.2 billion) maturing are not expected to be able to refinance at maturity.

Note that in 2016 and 2017, not only are the percentages much higher, but the total volume of loans maturing (ones that were originated in 2006 and 2007) is also greater. In total, this amounts to more than $140 billion of loans that are not expected to pay off at maturity.

These are not distressed properties, and the loans would otherwise not be in default.

So if we can see this wave of maturities coming, is there anything that can be done about it? The short answer is: absolutely. We can address this problem ahead of time, straight on, and figure out which deals are going to need to be extended.

Avoiding perils

One problem with waiting until the last minute to extend is that it puts owners in an awkward position with respect to their tenants. Borrowers may ask if it is worthwhile to pour so much time and so many resources into retaining and attracting tenants or attracting new ones if they are going to end up losing the property anyway. This, in turn, creates a ripple effect with tenants, who might look to relocate if they can’t get solid assurances from the property owners that a new lease with tenant improvements is on the horizon. And this could lead to bigger problems, if CMBS lenders don’t face the looming problems and if they haven’t learned lessons from the recession.

Today’s distressed properties don’t appear to be distressed. Typically, they are doing just fine. Instead, it is the loan that is distressed. And a distressed loan that cannot ultimately be fixed becomes a distressed property.

To avoid a trip down this dangerous path, commercial mortgage brokers need to work closely with real estate owners on upcoming loan maturities to ensure they can pay off their loans. If there is any concern about the ability to pay off the loans at maturity, they need to approach the servicer as soon as possible.

Hopefully, CMBS servicers will be receptive to working on these issues in a proactive manner. If not, the image of vacant malls, office buildings and hotels with unkempt landscaping and squatters will become more commonplace throughout the upcoming wave of maturing CMBS loans.


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