Commercial real estate (CRE) sectors have not escaped the perma-crisis era in which we live, and the worst appears yet to come. First, hospitality and retail suffered setbacks with pandemic lockdowns. Then, the persistence of work-from-home and employee resistance to returning to the office drastically changed the flow of workers to the office and urban centers. Now, before those issues are resolved, a significant number of CMBS loans are set to mature at a time of rising interest rates and threats of a market-wide credit crunch. With these events conspiring, parties should prepare for foreclosures, losses and resulting litigation.
As we previously reported, a substantial number of CMBS loans will soon need to be refinanced. Overall, more than 50% of outstanding commercial mortgages will need to be refinanced in the next two years. In the office segment, the Mortgage Bankers Association has predicted that $190 billion of the $750 billion in outstanding office loans are maturing in 2023 and another $117 billion are maturing in 2024.
Up until recently, regional banks could be counted on for a significant amount of new CRE originations. But in the wake of the collapse of Silicon Valley Bank, Signature Bank, and First Republic, regional banks are now straining under the public’s loss of confidence in them. Some, like Valley Bank, are doubling down, and some, like PacWest, are trying to back off. The FDIC has been trying to sell Signature Bank’s loan portfolio, heavy with commercial real estate loans.
Even for financial institutions that survived this first wave of failures, issues with their CRE portfolios could lead to a second crisis.
The post-pandemic landscape looks cruel for CRE. Overall, the surge in interest rates is depressing commercial real estate values. There are also significantly more variable rate commercial mortgages since the last period of interest rate spikes. Trepp data shows that variable rate loans make up approximately 60% of the CMBS issuances in 2021 and 2022, compared to just 15% back in 2005-2006. Interest rate hedges are more costly.
For office space, the shift to hybrid office usage is expected to inevitably lead to some tenants choosing to downsize, resulting in lower occupancy rates and valuations. These pandemic/post-pandemic circumstances may make it even harder for this sector to bounce back compared to past crises. Retail has already gone through a contraction with the rise of online shopping. Is this the moment offices face a similar behavioral shift?
There is some good news. As J.P. Morgan points out, offices “represent only 14% of total CRE assets in the United States” This segment of commercial real estate is not so large as to bring down the whole economy and not all areas of commercial real estate have the same problems. Office vacancies may be at an extreme high, but industrial construction remains strong.
Still, the effects of recent banking turmoil are an added pressure and CMBS investors are being directed by investment advisors to focus on top-quality CMBS.
Spreads are widening and new issuance is falling. Trepp reported that the Q1 quarterly volume for domestic, private-label CMBS was down 79% year-over-year to only $5.98 billion, a level not seen since 2012.
As S&P has noted, CMBS performance and ratings will depend upon a variety of unique factors that may not apply across the board to all properties (including building, location tenant/industry mix, rollover risk, office utilization and land values.) From their most recent report, retail and lodging have been improving, though regional malls remain at risk. But per S&P office values have decreased by 25% in the past year.
Fitch has been predicting fluctuations in delinquencies this year. Trepp called the May 2023 delinquencies a “tipping point.” The Trepp CMBS delinquency rate reached 3.62% in May which is a 14-month high and is the “largest [basis point increase] since June 2020, driven by office delinquencies.
A decrease in valuation can be a significant event, greatly impacting investor rights in CMBS deals.
Depending on the terms of the agreements, delinquencies, borrower insolvency events, or modifications of material economic terms could trigger an appraisal reduction event, which leads the servicer to conduct a new appraisal of the property, and potentially, results in an appraisal reduction amount (ARA) that reflects unrealized losses. The appraisal reduction may equal the excess of the outstanding principal balance of the loan minus 90% of the adjusted appraised values of the mortgaged properties securing the loan.
An ARA can impact subordinate certificateholders through reduced distributions of principal and interest and shifting of control rights (generally held by the most junior class that has 25% or more of its initial balance left). With so much at stake, disputes may arise over whether a triggering event has occurred, the appraisal, the ARA, the formula utilized to calculate the ARA and whether control rights have shifted.
For example:
With valuation playing such a significant role in control rights under CMBS deals, big swings in real estate valuations are flashing warning signs of increased litigation. Claims will likely be based on the triggering events and appraisal-related provisions discussed above. Currently pending CRE lawsuits are providing a blueprint for future disputes, just as the sector is about to hit “the wall.”
Nicole Serratore, an attorney in the Insolvency + Finance Group at Davis+Gilbert, contributed to this post.