Somewhere Over the Rainbow: A Stormy Commercial Real Estate Forecast
As we began writing this article, the National Weather Service issued a severe weather alert warning of heavy thunderstorms, hail, high winds and tornadoes in our area.
07.19.23
The stormy weather was a perfect metaphor for what has been brewing in the commercial real estate market during the last 12 months or more, and the news headlines of late bear this out:
- Distressed Sales Rise in Beleaguered Office Market (Wall Street Journal, May 16, 2023)
- The Return to Office Has Stalled (Wall Street Journal, May 16, 2023)
- The Tipping Point Came: Delinquency Rate On CMBS Loans Shoots Up (Bisnow, June 2, 2023)
- Commercial Property Faces Biggest Interest-Only Loan Bill (Wall Street Journal, June 6, 2023)
- Borrowing Costs For CMBS Loans Jump To 7%, Doubling Pandemic Lows (Bisnow, June 12, 2023)
- Renters Are About to Get the Upper Hand (Wall Street Journal, June 13, 2023)
- Fed’s Powell Suggested July Rate Rise Is Likely, Analysts Say (Wall Street Journal, June 15, 2023)
- New Glut City (New York Magazine, July 17, 2023)
Beyond the headlines, the underlying data is particularly grim in the office sector. It has been reported that values have already fallen 30% from pre-COVID-19 levels and are expected to fall a total of 34% before beginning to recover in 2024/2025. Vacancy rates were at 17.8% at the end of the first quarter of 2023 (the highest in 30 years) and are expected to peak at 19.3% in the third quarter of 2024, with downtown markets having the largest share of the hardest-hit buildings, and office utilization in the top 10 cities at roughly 50%. Of the approximately $4.4 trillion of commercial real estate debt currently outstanding, about $836 billion (19%) is secured by office properties and approximately $140 billion is coming due in 2023. The COVID-19 pandemic broke the historic relationship between job growth and increasing office absorption and the present state of the office market makes underwriting an office loan very difficult.
So, with commercial property values falling, vacancy and interest rates rising, office utilization rates remaining far below their pre-COVID-19 levels, and a wall of loan maturity dates looming, what should an office borrower do (or not do)? Well, like most things in life, it depends.
If you are a borrower that owns office property, the first principle should be to do no harm. Do not do anything that can make the situation worse. It is like the old saying: if you find yourself in a hole, then stop digging. But, to ensure that you do not make the situation worse, borrowers need to ensure that they understand what their existing loan documents say, including key definitions and borrower’s ongoing affirmative and negative covenants.
Sometimes, borrowers ask whether it is better to ask for forgiveness than to ask for lender consent. For example, a borrower may need to sign a lease amendment to retain a key tenant, but under the loan documents, the lease amendment requires the lender’s consent. Our answer is generally always the same: borrowers should not do anything that requires the lender’s consent under the loan documents without obtaining the lender’s consent because such conduct may trigger a default, default interest, a cash sweep and other unfortunate consequences under the loan documents. But if the loan documents contain a recipe for obtaining “deemed lender consent,” then by all means, borrowers should take advantage of it—just make sure to follow the recipe.
Further, if cash management is triggered, a borrower should not refuse to comply with instituting cash management as such conduct generally will trigger a default, fees may start to accrue and there may be recourse carve-out exposure under the recourse carve-out guaranty. Even if a borrower thinks that the lender’s determination that a cash management trigger has occurred is incorrect, it is prudent to cooperate in instituting cash management and have a simultaneous conversation with the lender about the calculations or events giving rise to the cash management trigger.
What if net operating income is not sufficient to pay debt service? Then the borrower should contact the lender/servicer and explain whether this is projected to be a temporary shortfall or one that is anticipated to be prolonged and detail the borrower’s plan to resolve the shortfall. Communication and continuing to turn over the net cash flow are key to maintaining credibility with the lender/servicer.
One thing is for sure; the current commercial real estate environment will present both challenges for some and opportunities for others. Assembling a team that understands those challenges and opportunities and is adept at navigating the complex landscape of today’s rapidly evolving market is the key to a successful outcome. Please reach out to us to schedule a consultation to see how we can be part of your solution.
Co-authors Stephan Cutler, co-chair and Alexandra Hill, partner are members of the Real Estate and Finance Department at Klehr Harrison.