The economic environment has shifted drastically since the COVID-19 pandemic. Government provided economic stimulus and supply-chain issues fueled historic inflation. However, spending and consumption continued which caused the Federal Reserve to increase rates at a dramatic pace leading to interest rates not seen since the Great Recession. “Work norms” have significantly changed whereby employees are no longer in the office all week. Major cities have significantly transformed due not only to these factors but geo-political factors whereby properties previously hotels are now shelters and major retailers are exiting these localities. Although these issues are not completely the same for smaller cities and towns, there are still challenges on the commercial real estate front and for those financial institutions that lend to them. We’ve created this white paper with two of our industry experts in order to discuss and share perspectives from both sides in an attempt to educate the others on what we’re seeing.
During the COVID-19 pandemic, there were concessions available to borrowers that were not previously acceptable in nature or widely used. Those accommodations coupled with the stimulus that borrowers received helped to ensure through the pandemic that essentially no losses were recognized by financial institutions as it relates to loans in general. As noted above however, there has been a significant shift in the economic environment that that has been significantly impactful to Commercial Real Estate (CRE) borrowers and the risk profile associated with these borrowers. This is something that the borrowers and the lender will need to navigate together to ensure the best outcome for both.
The rise in rates over the past few years has significantly changed the borrower’s ability to repay. All indications are that beginning in 2024, the rates will begin to drop. However, it is not anticipated to be in large increments or at a rapid pace. Therefore, for any commercial real estate borrower that has a borrowing that is either set to renew, expire, or reset the consequences are major as it relates to new terms – your payment WILL significantly increase.
Commercial real estate values have taken a hit due to economic downturns, changes in consumer behavior, and the ongoing impact of global events, as discussed above. Developers who invested in properties with the expectation of steady appreciation now find themselves dealing with declining values, making it challenging to refinance existing loans.
According to the U.S. Real Estate Market Outlook 2024, published by CBRE, real estate values for most property types are unlikely to fully stabilize until mid-2024. Office cap rates rose by at least 200 basis points between early 2022 and late 2023 (depending on market), which implies 20% declines in values. The decline in property values and challenges in refinancing have heightened the risk of foreclosure for some commercial real estate developers. This adds pressure to quickly find viable solutions to maintain ownership and control of their properties.
Building owners should start early in proactive conversations with tenants to renegotiate lease agreements. This may involve adjusting rent structures, offering lease extensions, or providing other incentives to retain tenants and ensure a steady cash flow.
Other strategies are being employed by property owners as well, such as repurposing space and seeking non-bank financing. Building owners are exploring creative ways to repurpose commercial space to meet evolving market demands. This may involve converting office space into mixed-use developments, incorporating residential components, or transforming retail space to accommodate e-commerce fulfillment centers. Adaptive reuse can breathe new life into struggling properties.
Many commercial real estate owners are actively seeking partnerships and alternative capital sources to inject liquidity into their projects. Joint ventures, partnerships with institutional investors, or seeking private equity can provide the necessary funds to address maturing loans and implement value-enhancing strategies. Developers are also taking advantage of various tax credits and incentives when structuring deals and attracting new investors, such as historic tax credits, cost segregation studies and energy-efficient credits and deductions (such as 179D).
In the summer of 2023, the agencies (FDIC, OCC, Board, NCUA) issued a statement that replaced guidance that was issued in 2009 on Prudent Commercial Real Estate Loan Workouts. Stressed within the guidance is the importance of financial institutions constructively working with borrowers experiencing financial difficulties. This guidance provides financial institutions with sound principles and expectations of regulators with respect to their handling of loan accommodations and workouts including (1) risk management, (2) classification of loans, (3) regulatory reporting, and (4) accounting considerations. Regulators recognize that providing borrowers with accommodations and workouts are ultimately in the best interest of the borrower as well as the institution and therefore as long as they are conducted in a prudent manner the institutions will not be subject to criticism for engaging in these efforts nor will the modified loans be subject to adverse classification solely because the value of the underlying collateral has declined to amount that is less than the outstanding loan balance for borrowers that have the ability to repay. This guidance also explicitly addressed short-term loan accommodations (which became increasingly used during the COVID-era).
Since the March 2023 “Banking Crisis”, financial institutions have been required to be more cognizant of capital and liquidity levels which in turn has led to “turning off lending” in some instances. Credit and underwriting standards have definitely become more stringent since this crisis occurred.
What do we recommend? Reach out early. Be communicative and honest regarding your financial position. The ultimate goal should be to find something that works for you both the borrower and the lender.
If you need further guidance or have any questions on this topic, we are here to help. Please do not hesitate to reach out to discuss your specific situation.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.