It has been a challenging year for many commercial real estate owners. They’ve had to navigate through sky-high inflation, rising interest rates and lower occupancy rates in many markets. The overall health of the U.S. economy has a major influence on commercial property values. A strong economy may lead to growing demand and increasing values, while a weak economy can result in lower demand and decreased values.
It’s important to note that these economic factors are interrelated and may vary across different regions of the country. Consequently, it’s essential for the commercial mortgage broker to stay abreast of economic indicators and trends that drive loan demand.
“To find a solution that does not include bankruptcy or foreclosure, both the borrower and the lender must establish open and transparent lines of communication.”
It is paramount for the mortgage broker to understand the factors that impact commercial property prices. By untangling these key influences, brokers will gain important insights into what shapes a property’s worth, which enables them to make informed choices that match up with the financial goals of the borrower and lender.
The factors that tend to be most important to brokers and borrowers include the state of the economy, the inflation rate, interest rate trends, and the availability of debt and equity capital. Other factors to keep in mind include the property’s location, its condition, and the number of active investors and speculators in the market.
Without question, the two major influences on the current market are inflation and the Federal Reserve’s ongoing interest rate hikes. Beginning in the spring of 2022, the Federal Open Market Committee (FOMC) raised interest rates 11 times in a 17-month period in an attempt to corral inflation back to its target of 2%.
The consumer price index, however, stayed stubbornly high this past September at 3.7%, making it appear that the Fed has more work to do. The FOMC held the federal funds rate steady that month, but Fed Chairman Jerome Powell emphasized that it’s too early to claim victory and that officials are prepared to raise the benchmark rate further, if necessary.
The commercial mortgage markets are also facing a higher degree of ambiguity as economic uncertainty continues to restrain them. Many financial institutions are expected to face major challenges for the foreseeable future, driven by slow or potentially negative growth rates, high inflation and further increases in interest rates.
In addition, underwriting standards are tightening. According to the Fed’s Senior Loan Officer Opinion Survey for second-quarter 2023, 51% of banks tightened their terms of credit for commercial and industrial loans to medium and large businesses during these three months. That share rose from 46% in the prior quarter. For small businesses, 49% of banks reported that credit terms were stiffer in the second quarter, up from 47% in the previous quarter.
These problems may be exacerbated by the estimated $1.5 trillion in commercial mortgages that are reportedly set to mature in the next two years. As a result of rising interest rates and declines in property values, there are growing concerns that lenders may not be willing to refinance these maturing loans on terms that will enable the borrowers to service the debt on a timely basis.
For veteran commercial mortgage brokers, this isn’t the first time facing economic uncertainty, high inflation, interest rate hikes and credit tightening. But this might be the most challenging climate since the Great Recession, when home prices dropped by more than 27% and delinquency rates on subprime loans peaked at 30% in 2010.
After navigating through difficult times in the past, the market will surely recover once again. But this commercial real estate downturn will be costly, many will experience major losses and, unfortunately, there will be litigation and foreclosures.
The current problems are numerous and not easily categorized, but for ease of discussion, let’s focus on a single scenario. Although this may be an overly simplified explanation, there are certain deals that were originally well conceived and seemingly well structured, but because of timing, they may be having difficulties meeting their financial obligations.
Deal with defaults
When a commercial mortgage defaults, it’s crucial for all parties to steer through the situation with great caution. Loans in default are challenging, but with the right approach, it’s possible to mitigate potential losses and find a favorable resolution for all parties involved.
A case in point is a commercial property experiencing growing financial problems due to a decline in occupancy. The property is suffering from a major loss of net operating income (NOI), which will result in a higher capitalization rate and, in turn, will reflect a lower value. Furthermore, the loss of NOI may be so large that the asset can no longer meet its debt-service requirement, resulting in mortgage default and a possible foreclosure.
This would be the worst possible outcome in which everyone loses. Unfortunately, we may see this scenario play out many times in the coming years.
Out of this chaos may come opportunities for experienced and forward-thinking mortgage brokers. By acting as intermediaries, brokers can demonstrate their value by developing creative solutions that benefit all parties. To find a solution that does not include bankruptcy or foreclosure, both the borrower and the lender must establish open and transparent lines of communication. They must provide timely progress reports that will help create a favorable working environment.
The first step in this long process is for all parties to have an in-depth understanding of the economic and social factors that are influencing the market and the financial stability of the asset. This analysis cannot be done in a vacuum. The study must be done within the larger context of the commercial real estate industry, existing economic conditions at the national and local levels, and the financial wherewithal of the borrower.
Know the numbers
The second step is to develop a clear and complete understanding of the current financial condition of the property. All parties must understand the capacity of the borrower and the project at hand — in other words, know the numbers.
To aid in the financial analysis, various financial reports will be needed, including the balance sheet — which reflects the project’s liquidity, valuation and leverage. The income statement — which reflects the gross income, operating expenses and net profit — is also crucial.
Other required financial information includes the net operating income statement, which explains the gross rental income, operating expenses and NOI before debt service. Tax returns show the income, profits, losses, deductions, credits and tax liabilities of the project. Ideally, three years of each statement should be provided.
The purpose of this in-depth analysis is to develop a clear and complete understanding of the asset’s current financial situation. This includes the debt-service-coverage ratio, leverage, liquidity and trend lines of other appropriate financial metrics.
Once the financial review is complete, a set of action plans and financial pro formas can be developed that are based on how to best prepare for a future that is uncertain at best. A pro forma should be designed to anticipate multiple scenarios, include strategies for each scenario and a determination of whether these strategies can be successfully executed. It should explain how to identify and execute the most likely strategy, and how to rapidly adopt an alternative plan if market forces dictate.
Armed with this essential information, it’s time to make tactical decisions regarding the future of the project. Can the project meet its current debt-service requirement? Probably not, which is why a problem exists. The next logical question is, what is the project’s current debt-service capability?
The existing and projected financials, including the NOI statement, will allow the borrower and lender to identify an appropriate level of repayment based on the project’s current debt-service capacity. Another option, if the lender is receptive, is to decrease the existing interest rate and/or extend the repayment terms. The objective is to keep the loan on active interest accrual, maintaining some level of cash flow to the lender.
A final (and maybe least desirable) option is to place the loan into forbearance. This will temporarily pause payments for a specific period, and it generally means that the loan won’t accrue interest.
The lender may or may not agree to this option. A possible benefit is to allow the borrower sufficient time to regain their financial footing and start a revised repayment plan. In many cases, a lender will grant forbearance to a borrower due to unforeseen financial difficulties. After all, the lender typically doesn’t want to seize the property.
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By working together and exploring possible options, the commercial mortgage broker, borrower and lender may find a mutually beneficial outcome. But they must accept the fact that the parties will probably suffer some level of financial loss. The objective is to minimize the loss and normalize the situation at the earliest possible date. The result must be the best possible solution. ●