There is an old adage that “your first loss is your best loss.” That comes to mind this week with news that several major lenders involved in commercial real estate (frequently referred to as “CRE”
are eager to sell off – at a significant loss - CRE loans that are currently performing as agreed. Why would they sell off loans that are performing well, and why would they take a loss to unload good loans?
There is a very good reason. Specifically, there is an approaching debt refinance crisis on CRE that is looming large and drawing closer every day.
Here’s some quick background:
• CRE properties are office buildings, shopping centers, hotels, apartments, etc. that produce income from rent paid by tenants.
• The owners typically finance these properties for terms of 5 to 10 years (but on a 20 or 25-year payout) with a balloon payment that is due at loan maturity.
• The amount borrowed for the loan must obviously be less than the value of the property.
• Rent income must be able to support the debt.
Here’s the problem:
Maturing loans likely have rates around 4% or less right now, but to renew the loan for another 5 or 10 years the new rate is going to be closer to 8%. On a $20 million dollar loan, an 8% loan on a 20-year payout has annual payments totaling about $2 million, versus approximately $1.5 million on a 4% loan.
Uh oh. To cover the extra half-million of interest paid each year means that rents must be increased to cover the debt service, or else no bank is going to provide the refinancing. But just the opposite is playing out between landlords and tenants, especially regarding office space. Office vacancy is critically high following the double punch of Covid-era work-from-home combined with the anarchic destruction of major city cores.
It gets worse, with high vacancy in dying cities, the value of office buildings is in free fall, if a buyer can be found at all.
And it’s not just office space, any CRE property that is in a dying blue city run by a Pol Pot mayor is becoming unsustainable, including hotels and retail shopping centers, as well as office buildings. These are just a few of the headlines in recent weeks:
“Owner Defaults on Loan for Two Downtown San Francisco Hotels” [San Francisco Examiner – 6/06/2023]
Park Hotels & Resorts — which owns the 1,921-room Hilton San Francisco Union Square and the 1,024-room Parc 55 San Francisco — announced Tuesday that the company will default on its $725 million nonrecourse, commercial mortgage-backed security loan, which is scheduled to mature in November.
There is a wave of CRE loans about to mature, but they cannot be refinanced for multiple reasons, including:
• The value of the property has plummeted below the balloon amount.
• The market – and existing leases - will not allow for rents to be increased to cover the increased cost of higher interest rates.
So what do the owners of CRE properties do? They would love to sell the properties, of course, but the market has collapsed, so the property can only be sold for a price far less than the balloon amount on the loan.
If the property owners can’t refinance the property, nor can they can’t sell it, they are left with one ugly option…surrender the property to the lender as a foreclosure.
So, banks and other CRE lenders are now looking at a pipeline of defaulting loans heading toward them. And what does a bank do with a foreclosed property? It sells it off at a distressed price. And the more foreclosed properties that are hitting the market, the less they are worth. Which means that the bank keeps taking bigger and bigger losses as their foreclosed properties hit the market.
That is where we are right now. Banks are full of these loans that are going to be un-refinanceable, but the clock can’t be stopped and no one can stop the calendar pages from turning. The situation is about to get really bad, with no good solution.
Which explains this story from the past week:
“Property Loans Are So Unappealing That Banks Want to Dump Them” [Bloomberg – 8/07/202]
Lenders including Goldman Sachs Group Inc. and JPMorgan Chase & Co. have been trying to sell debt backed by offices, hotels and even apartments in recent months, but many are finding that tidying up loan books is no easy feat when concerns about commercial real estate have surged.
Banks seeking to sell commercial-property loans are encountering a dried-up market with few options for an easy exit.
“Even if most of these are performing loans today, they’re trying to reduce their exposure by selling loans at a discount as they head into a refinance cycle,” Hagood said. “A lot of these banks will say, ‘I’d rather take the hit there than take the hit on a foreclosure and have to deal with the asset after.’”
Goldman and JPMorgan, along with other banks including Capital One Financial Corp. and M&T Bank Corp., have sought to sell property debt in recent months, seeking buyers both for one-off sales and transactions for portfolios of loans, according to people familiar with the matter, who asked not to be identified citing private information.
A known, manageable loss now makes perfect sense if it gets a CRE loan off the books. But who would want to buy a ticking time bomb at any price?
Some CRE loans are already hitting maturity and blowing up, including one that finances 30 Marriott Courtyard hotels.
”Cerberus, Highgate Miss Payments on $415 Million Hotel Mortgage” [Bloomberg – 7/24/2023]
Cerberus Capital Management and Highgate missed two months of payments on a $415 million loan for 30 Courtyard by Marriott hotels, another sign of spreading trouble in commercial real estate.
Cerberus and Highgate have requested an extension of the floating-rate loan, which matured in July, according to a servicer report.
“Borrower stated that they do not have enough funds to cover the shortage and the regular monthly debt service,” according to the report.
I’m trying not to write as many stories as I had been predicting “Doom!” However, when you see a freight train barreling down the tracks at a tanker truck stuck on a railroad crossing, it’s not a wild prediction to assert that there is about to be a big explosion. The CRE debt maturity crisis is that freight train. I fear just how bad the explosion will be.
[buck.throckmorton at protonmail dot com]