These complex commercial property changes are having significant impacts on various stakeholders, especially those involved with finance. It is important to seek clarity and perspective on these emerging trends, their implications for all involved and ways for finance professionals to effectively navigate this evolving terrain.

“Recent trends in the commercial real estate market, particularly in renowned technology hubs like San Francisco, have included sharp downward movements in property valuations.”

At the forefront of the massive change are mortgage brokers who in the past had standardized models to assess the risks associated with properties. With fluctuating values, especially in major markets such as San Francisco, Chicago and New York City, these models now need a fresh lens.

Properties that were traditionally perceived as lucrative and virtually recession-proof are now enveloped in layers of uncertainty. This newfound unpredictability calls for a more meticulous and nuanced approach to risk assessment, ensuring that every potential pitfall is accounted for.

Recent trends in the commercial real estate market, particularly in renowned technology hubs like San Francisco, have included sharp downward movements in property valuations. As the backbone of the U.S. tech industry, cities like San Francisco have traditionally commanded premium prices. But current data paints a different picture and indicates a directional shift in macroeconomics.

Office-space dilemma

The commercial real estate market in San Francisco includes a few recent sales of office buildings at shocking discounts. Some properties are being discounted by 60% to 70% or more compared to what they were valued at just a few years ago.

Historically, office spaces in business hubs have been in high demand, driven by a thriving tech community, startups and ancillary businesses. But a combination of factors, including the broader acceptance of remote work following the COVID-19 pandemic and the high operational costs associated with maintaining offices in prime locations, has led to reduced demand and has subsequently pushed down valuations.

“As always, relationships are the bedrock of the mortgage industry. In these times, a network that includes both quality lenders and borrowers is an invaluable asset.”

JLL reported that San Francisco’s office vacancy rate increased to more than 30% in third-quarter 2023. It was the 15th consecutive quarter in which the vacancy rate increased. The dip in the city’s office valuations has had a cascading effect, leading to a deluge of tax appeals. Among the major players, Brookfield Properties requested a 75% reduction in the value of an office tower on Market Street, while Columbia Property Trust sought a 50% cut on three of its office holdings.

Blackstone wasn’t far behind, appealing for reductions of 20% to 25% for three of its waterfront properties. In the fiscal year ending this past June, tax filers in the city appealed for an average reduction of 48% on property assessed at more than $60 billion.

For cities, this wave of appeals spells fiscal strain. San Francisco, which was already grappling with a projected budget deficit of $780 million through 2025, anticipates refunding $167 million due to these property tax appeals.

Cook County troubles

While San Francisco’s declining values and increasing tax appeals create a challenging landscape, property owners thousands of miles away in Cook County, Illinois, are grappling with an entirely different kind of shock: skyrocketing property tax bills. About 40,000 residents in Cook County are filing appeals.

Amid a backdrop of rising inflation that negatively affects consumers, some commercial real estate owners have seen their tax bills double or triple in a single year. Data obtained from the Cook County Treasurer’s Office indicated that tax bills for some 20,000 properties increased by 100% or more between 2021 and 2022. A majority of these properties are residential but some are commercial.

One particularly jarring case came from the Roseland neighborhood on Chicago’s South Side, where a homeowner was served with a property tax bill that jumped 1,000% year over year. Meanwhile, in the Chicago Lawn neighborhood, a senior citizen received an 884% hike in her tax bill.

Cook County Assessor Fritz Kaegi’s office attributed these sharp increases to neighborhoods that have “undergone significant change” and that many properties were “most likely previously undervalued.” But these explanations tend to provide little consolation. Some business owners told local news services that they might not be able to keep their doors open.

Future implications

The underlying sentiment in Cook County reflects a growing sense of alarm and uncertainty that is being felt in many major cities. While property owners understand the need for periodic tax hikes to finance county services and pensions, they feel cornered by the extremity of these increases, especially given the limited time they have to arrange for payments after receiving their bills.

This may be part of the new normal as real estate markets change and fluctuate, sometimes in extreme ways. This evolving landscape is going to be difficult to navigate, especially for those in the realm of mortgage finance.

Mortgage brokers will need to develop a nuanced approach to risk assessment to find their way through this new environment. And many lending standards will need a fresh look. This includes the loan-to-value (LTV) ratio. A cornerstone in the mortgage domain, LTV ratios are greatly influenced by property valuations.

With declining prices, these ratios are bound to witness significant shifts, which could impact the capacities for potential borrowers. A property that might have fetched a substantially high loan amount a year ago might now merit considerably less, reshaping the lending landscape.

Interest rate impacts

The changes in property valuations don’t stop at risk assessments and LTV ratios. They extend their reach into the very core of property financing — interest rates and loan terms.

Many lenders, in their bid to shield themselves from potential defaults, have adopted a more conservative stance. This could manifest in the form of adjustable interest rates or more stringent loan terms, particularly for commercial mortgages in areas that are experiencing sharp valuation declines.

The age-old adage of not putting all your eggs in one basket seems more relevant than ever. The unpredictability of certain markets underscores the importance of diversification. Instead of heavy investments in a single market or property type, spreading one’s portfolio across different regions and diverse property segments might emerge as the wise strategy. This approach hedges against potential losses in one sector and also offers avenues for gains in others.

The path ahead

In the intricate landscape of today’s real estate market, commercial mortgage brokers are presented with a unique blend of challenges and opportunities. To navigate these waters, a holistic approach that combines traditional expertise with adaptive strategies is essential.

Central to this is an emphasis on a data-driven strategy. As professionals deeply entrenched in the commercial mortgage ecosystem, the ability to harness and interpret current market data is indispensable. Beyond the standard metrics, diving into granular data points can offer pivotal insights, allowing for timely and strategic decisionmaking. In a volatile market, data-informed strategies will set brokers apart.

Data cannot exist in isolation, no matter how comprehensive it is. A deep understanding of local market dynamics is more crucial than ever. Each commercial district holds unique challenges and potential. Leaning into expertise to better discern microtrends can provide a leg up, ensuring that every deal is optimized for success.

As always, relationships are the bedrock of the mortgage industry. In these times, a network that includes both quality lenders and borrowers is an invaluable asset. It ensures seamless transactions, fosters trust and positions you as the go-to expert amid market uncertainties.

It’s crucial to stay attuned to the broader policy landscape as well. Decisionmakers, including city officials, are actively working on frameworks to steady the commercial real estate market. One example is San Francisco Mayor London Breed’s proposal to offer tax incentives that would encourage companies to set up offices in the city. Keeping a finger on the pulse of such policy shifts can offer you and your clients a strategic advantage, ensuring that you’re capitalizing on every available opportunity.

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The path forward for commercial mortgage brokers, while laden with complexities, is also ripe with potential. A combination of data-centric strategies, deep local-market insights, solid relationships and a grasp of evolving policy directions serve as a compass to guide brokers through these times. Their expertise, paired with these tools, will ensure not only survival but success in the evolving commercial real estate landscape.

The intersection of declining valuations and soaring tax appeals has caused uncertainty for commercial real estate owners. By understanding these shifts and their implications, mortgage brokers can chart a course that not only navigates through such challenges but also identifies potential opportunities for future growth and innovation. ●

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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.

Key influences

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.

Tough times

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.

Take action

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. ●

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There is no end to the projects underway, including an ongoing adaptive-reuse plan for Los Angeles, which has been active since 1999, mostly in the city’s downtown core. In the first 15 years of the program, more than 12,000 housing units were developed, many in converted bank buildings. This year, planners have decided to expand the program citywide.

“We are in the Wild West with these projects, and developers like predictability and certainty in what they do.”

– Brooks Howell, residential leader and principal, Gensler

In Chicago, former mayor Lori Lightfoot is championing the LaSalle Street corridor revitalization, a massive $1 billion project that will repurpose 2.3 million square feet of vacant space in the city’s famed central business district into 1,600 mixed-income apartments. New York City also has a conversion program in place, but officials this year proposed state and city zoning changes that would extend flexible conversion regulations to an additional 136 million square feet of office space.

Many academic groups and private research firms are joining up with the adaptive-reuse movement. Many believe this process is a partial answer to the nation’s housing problem. A 2022 Rand Corp. report, for instance, identified 2,300 commercial properties in the Los Angeles area that, if fully utilized for residential purposes, could produce between 72,000 and 113,000 apartments, depending on the mix of unit sizes. This would equate to 9% to 14% of the housing units that Los Angeles County will need to produce by 2030. The report found that adaptive-reuse projects to convert hotel and motel rooms into studio apartments is typically a lower-risk proposition than converting office and retail spaces.

For all the excitement about such projects, however, there isn’t as much activity happening as one might expect. CBRE found that an average of 41 office conversions were completed annually between 2016 and 2022. The real estate services company estimates that the number of projects is expected to double, due to increased incentives and other help from state and local governments.

There are many difficulties for these projects to overcome, but the one aspect that may be insurmountable for many buildings is that the projects don’t tend to pencil out. Most office building conversions are too expensive to make the process financially feasible.

“There’s a lot of ink being spilled on this subject right now,” says Brooks Howell, residential leader and principal at Gensler, a global architecture, design and planning firm. “But the biggest challenge is the major cost mismatch. These buildings are going to have to sell really, really cheaply to make conversions work.”

Howell points to many parts of the building that can be problematic, including the size of the property. The sweet spot for most apartment buildings is about 350,000 square feet, which allows for the greatest efficiency in using all of the space. Larger buildings often need to be mixed-use projects with some floors remaining as office space. This is a problem because, under current circumstances, the office space may not have tenants and would essentially be unused, reducing the value of the building.

But there are many other problems with conversions, from replacing the skin of the structure, to putting in windows that open or adding balconies, which endanger the integrity of the facade. Other than the building itself, there are a variety of zoning regulations that vary from city to city which can upend a project.

There are also mechanical issues. Howell says that some of the reasons that office-to-apartment conversions are so expensive aren’t always the obvious ones. For example, it’s common to single out plumbing and other infrastructure aspects needed for apartments. Howell maintains that plumbing is a set cost and not as much of a problem as the building’s mechanical systems, including heating and air conditioning, which may cost tens of thousands of dollars per apartment unit if upgrades are needed.

“We are in the Wild West with these projects, and developers like predictability and certainty in what they do,” Howell says. “And you’ve introduced more unpredictability and uncertainty in this process. Not a lot of developers are comfortable with that, and I think that’s really what’s slowing the process.”

Due to the added costs, Howell maintains that most, if not all, of the buildings currently being converted are receiving some form of tax credits, usually because the properties are considered historic. It’s the only way for the numbers to make sense. He believes that for more conversions to work, it will require a coordinated effort by federal, state and local governments to develop tax breaks and other forms of financial incentives.

“The federal government is going to have to come up with some plan that allows this process to move quicker,” Howell says. “I’d love to see them step in and incentivize the conversion process. There are many reasons for it, including the fact that converting buildings is the most carbon-neutral way to build housing.

“The question is, how do we overcome all the different roadblocks? There is no coordinated and concerted effort to solve these problems, and there’s not one entity that seems to be in control.” ●

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“Since extending the current loan is likely the solution in so many situations, it is important that brokers understand how lenders and servicers are handling these cases.”

The current freeze in commercial mortgage activity has been ongoing for much of 2023 and sales transactions have dropped precipitously. According to a recent forecast from the Mortgage Bankers Association, commercial and multifamily mortgage lending is expected to fall to a total of $504 billion this year, down 38% from the total of $816 billion in 2022. In many cases, property owners who can afford to wait are choosing to do just that in hopes that interest rates will fall in the future.

Looming problem

A major problem may be looming in the future, however, as more than $1 trillion in commercial real estate loans will be maturing in the next few years. Mortgage brokers with clients who have maturing loans secured by office buildings or apartment complexes don’t have the luxury to sit and wait. Property owners are going to be forced to refinance at rates that are twice as high (or even higher) than their current loan, depending on the lender and the location.

Even the largest players are feeling the market effects. S&P Global Ratings announced this past October that it was putting Brookfield Property Partners on a negative watchlist, meaning that the Canadian real estate giant might be downgraded to junk status. Bisnow reported that the reason for the move is Brookfield’s large amount of maturing debt amid high interest rates and downward pressure on property values.

Brookfield isn’t alone. All borrowers are facing limited options. Refinancing is going to be difficult as lending for office buildings this year has slowed and nearly halted. And the sales options (assuming the value of an office property is more than the loan amount) are also limited as borrowers will be required to put a lot more cash into the deal. So, their only other option is to get the lender to extend the loan.

The property owners who have maturing loans secured by multifamily housing also don’t have the choice to sit and wait. Just like office owners, their options are limited. While there is an abundance of debt available in the multifamily sector, the interest rate on a new loan will, once again, be much higher than that of the current loan.

The loan-to-value (LTV) ratio will also be much lower for a new loan. Some lenders are now offering loans with maximum LTVs of 50%, which means that the borrower will likely need to use a significant amount of cash to pay off the existing loan. Luckily, there’s a durable market for multifamily transactions, so these properties can often be sold. The final option is to get the lender to extend the loan.

Extension issues

Since an extension is the likely solution in many situations, it’s important for commercial mortgage brokers to understand how lenders and servicers are handling these cases. First, brokers need to explain to borrowers that lenders have an advantage when they know that owners are desperate for an extension and have few other options. Lenders smell blood in the water. After all, what else is a borrower going to do but accept the term a lender is willing to give them?

Unfortunately, even when borrowers have good relationships with lenders, they’ll find this to be the case. Everyone working with commercial real estate is ultimately in the business of making money. When they see good opportunities to turn a profit, they go for it, so there is no faulting a lender or servicer for doing the same thing even when it may not feel fair to the borrower.

This appears to be what’s happening these days. It’s no secret that an owner’s options are limited, so they’ll usually have to accept the lender’s terms. Many borrowers wind up with two options: accept an expensive offer to extend or find a private lender, often known as a hard money lender, to refinance. In essence, the current lender is the lender of last resort.

Other borrowers, however, may qualify for other creative methods, such as a high-rate bridge loan, or they could sell the property. Although some of these options may be more expensive than the offer from their existing lender, they are still worth considering. The broker needs to emphasize to the client that the best thing they can do is keep all options open and approach the lender in plenty of time to pivot to the best solution.

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The lucky owners in 2023 may be those who didn’t have their mortgage mature. The owners in trouble today — and for a few years to come — are those who will see their loans come due. Unlike COVID-19, there are no vaccines for maturing loans. The best advice that commercial mortgage brokers can offer clients who face loan maturity issues is to plan ahead.

Brokers need to advise clients on debt issues or work with them to find the right advisers at least six months prior to the loan maturity date. Borrowers need to figure out what their options are and how their lenders are handling extensions. This information will allow them to be prepared for the process they’re about to begin. ●

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The disappearing distress of 2023 is an important mystery to solve. It will shed light on what to expect in the distressed market of 2024, which in turn has important implications on the broader retail housing market.

The first step in solving the puzzle of the disappearing distress is fairly straightforward: the monthly conversion rate of seriously delinquent mortgages to completed foreclosures. In the pre-pandemic era of 2015 to 2019, this monthly conversion rate averaged 1.96%, according to an Auction.com analysis of data from the Mortgage Bankers Association and Attom.

It’s helpful to put this metric in context. Given 1 million seriously delinquent mortgages, one could expect 19,600 completed foreclosure auctions per month and about 235,200 completed foreclosure auctions per year.

But the monthly conversion rate dropped dramatically in the final three quarters of 2020 and all of 2021, averaging 0.27% over these seven quarters. That’s not too surprising given the nationwide foreclosure moratorium on government-backed mortgages in place at that time. What’s more surprising is the post-moratorium conversion rate, which has averaged 0.71% since January 2022, although it has slowly inched higher over this period.

Why did the conversion rate decline? One would expect it to bounce back to its pre-moratorium average quite quickly, and possibly to rise above that average temporarily due to a backlog of delayed distress tied to the moratorium. That is, in fact, exactly what happened in the aftermath of the hurricane-induced foreclosure moratoriums of 2017.

But the post-pandemic moratorium rebound has been anemic at best, a result of at least two major changes in the distressed-market funnel. The first change is the massive increase in foreclosure prevention resources made available to mortgage borrowers and servicers during the pandemic that still continue in some form. On the loss-mitigation side, the most prominent resource that has gained widespread adoption is the zero-interest second mortgage that can be used to prevent payment shock when a delinquent borrower gets back on track.

The two main loss-mitigation mechanisms used to deliver this option are payment deferrals (for loans backed by Fannie Mae and Freddie Mac) and partial clams (for loans insured by the Federal Housing Administration). Both programs have been expanded to apply to non-COVID hardships. This change to the distressed-market funnel is less likely to have a permanent impact because it’s doing what loss mitigation has always been designed to do: give homeowners temporary relief without solving the underlying issue that’s causing distress.

A potentially more permanent change are sales that occur after the foreclosure process has started but before the property goes to foreclosure auction. An Auction.com analysis found more than 150,000 pre-foreclosure sales in 2021, up 38% from 2020 to reach the highest level since 2014. And because other types of distressed sales declined in 2021 due to the foreclosure moratorium, pre-foreclosure sales represented a record-high 64% of distressed sales for the year (as shown on the chart above).

This trend continued in 2022 after the moratorium ended. Pre-foreclosure sales once again accounted for 64% of all distressed sales for the year. And because pre-foreclosure sales involve a transfer of ownership from a distressed homeowner — drastically reducing the likelihood that the property will return to the foreclosure funnel in the near future — this could represent a more lasting change for the delinquency-to-foreclosure conversion rate. ●

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It’s an impending volume of maturities that Yardi called “worrying,” given the perfect storm of soft demand, low property prices, rising costs, all while lenders look to reduce risk and limit their exposure to office properties.

Consider that, by dollar volume, 16.1% of the total mortgage debt in the office sector will mature by the close of 2024 and 32.7% will mature two years later. Those maturing loans are concentrated in urban Class A properties and within the largest markets in the country, with Manhattan having the most at stake. New York’s most office-saturated borough has $19.8 billion of loans for 1,159 properties set to come due by next year’s end, nearly double the dollar value of Los Angeles, the market with the second highest dollar amount of maturing office mortgages.

Ten metros have more than $5 billion in office mortgages maturing by the end of 2024, and nine metros will see at least 20% of office mortgages by dollar volume come due at that same time. Metros with the largest percentage of mortgage volume coming due in the short term include Houston at 29.7%, Atlanta at 28.8%, Philadelphia at 26.7% and Chicago at 26.4%. Further out, 10 markets have at least $10 billion coming due by the end of 2026. By dollar volume, more than half of office mortgages will mature by the end of 2026 in Atlanta (52.6%) and Houston (50.5%).

Many of the markets with a large number of loans maturing also currently have high vacancy rates, including Houston (24.9% as of October 2023), Atlanta (18.7%) and Chicago (17.9%). That combination could spell double trouble ahead for such cities, with present weakness in demand meeting a large number of loans coming due — a model recipe for potential distress.

Distress, Yardi noted, is already starting to rise, with 5.8% of office loans pooled into commercial mortgage-backed securities (CMBS) delinquent in October 2023, according to the CRE Finance Council and Trepp. That’s up from 1.8% in October 2022 and 1.9% in December 2019. Additionally, roughly $9.8 billion of CMBS loans (comprising 8.3% of all such mortgages) were already in special servicing as of September 2023.

“Those negative numbers will increase as loans mature and properties face a funding gap — in other words, they qualify for fewer proceeds than existing debt in place because banks have grown more conservative while mortgage rates have shot up as Treasury and SOFR indexes rise,” said Paul Fiorilla, director of research at Yardi.

How much office distress will keep growing, Fiorilla added, largely depends on how long rates stay high and if they rise even more.  

“The worst case scenario is if the job market weakens while property values continue to fall and interest rates rise from current levels,” Fiorilla said. “A more optimistic scenario would have the employment market remaining strong while interest rates stop rising or even fall. In either scenario, office delinquencies are likely to jump, but the optimistic scenario would mitigate the pain as opposed to creating a larger crisis.”

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The Federal Reserve has continued with its mandate to curb inflation by raising benchmark interest rates. While data reflects that this policy has certainly contributed to the general downtrend in inflation throughout the year, the impact on commercial real estate has been dramatic and not so positive.

“It is difficult to be optimistic about the remainder of 2023 or the early days of 2024.”

This year will prove to be one of the more challenging in recent memory for commercial mortgage originators. At this point, the outlook for 2024 does not appear markedly different as the sector manages the higher interest rate environment, which will potentially result in a rash of loan defaults and modifications.

Myriad troubles

In the residential real estate sector, limited housing supply has contributed to elevated prices despite a higher interest rate environment. Conversely, the commercial property sector this year saw asset values and loan origination activity plummet across all segments. Office and retail have suffered the most as lenders pull back from these areas.

Coupled with a higher interest rate environment, the market dealt with a short-lived banking crisis that ended before it even started. Sure, some banks dissolved due to a series of problems, including mismanagement and a flight of deposits. But there were others, including the nation’s largest banks, that weathered the storm and became even stronger.

The calendar years of 2021 and 2022 were generally ones of prosperity in both the commercial and residential sectors, fueled by low rates and insatiable demand. But as Warren Buffett was famously quoted as saying, “You don’t find out who’s been swimming naked until the tide goes out.” Many banks did not sufficiently hedge their Treasury portfolios, leaving them exposed to higher Treasury rates.

A number of vertically integrated real estate companies also found themselves holding high-rate bridge or construction debt, and they had no true exit strategy as a result of higher rates hampering their debt-service-coverage ratios. Couple that with higher property taxes and exponential increases in property insurance, and you have a perfect storm for which there is no port.

Many lenders, originators, developers and operators have entered the market over the past decade. A portion of these newcomers thrived due to timing rather than knowledge or skill. But times have changed and many areas of the commercial real estate business have dried up. As an old saying goes, “When fish are swimming into the net, you are not truly a fisherman. It is when they don’t that you learn whether you are.” Many of these novices have found this year that they are not truly fishermen. Deals have not only been harder to come by but harder to qualify and close.

Dark outlook

It is difficult to be optimistic about the remainder of 2023 or the early days of 2024. The Federal Open Market Committee (FOMC) has stated that it will keep interest rates higher for longer to curb inflation. While the FOMC may not raise rates further, borrowing costs are likely to remain elevated for some time. This climate will restrict lending volumes for commercial real estate as deals will continue to be debt-service constrained, limiting proceeds.

There are also growing concerns about inflation in wages and services, which may push any rate-cut projections further into the future. Another major fear is that a wave of new multifamily properties set to be delivered will drag down rents and curb construction in this sector. In addition, increased costs for energy, labor and materials could add to the woes of multifamily operators as they move forward.

Nearly $700 billion in short-term, low-rate loans on multifamily housing are expected to mature in the next two years, and many of these will have problems being refinanced. The near future also will bring defaults for office properties in many major markets. But as more companies require workers to come back to their cubicles, there is hope that the office sector will make a comeback.

Another area that reaped a post-pandemic boost in demand was the industrial sector, although signs of softness have started to emerge. And hospitality, a sector that sees lender interest vary, is on the tail end of an upturn since the lifting of pandemic-era restrictions. Recently, the appetite for hotel lending has begun to wane.

Glimmers of hope

One area of commercial real estate that may show continued strength is owner-occupied loans. Lenders are aggressively pursuing such deals, as well as the potential depository relationships afforded by these business clients.

Lenders also prefer using the U.S. Small Business Administration (SBA) platform to facilitate these owner-occupied deals, offsetting risk and exposure. Additionally, the secondary market for SBA 7(a) loans remain robust and represents a far more profitable transaction to lenders — with a fraction of the risk.

Although it seems unlikely that lending volumes will increase soon, there are reasons for optimism due to the fact that virtually every deal financed during this period of higher interest rates presents a refinance opportunity down the road. This is because any deals closed today are, in essence, bridge loans of sorts as borrowers wait for rates to fall.

As a rule of thumb, it is best to limit prepayment penalties on any newly financed transactions. Mortgage brokers should also avoid any defeasance, rate-swap or yield-maintenance transactions so that when rates do come down a bit, borrowers have no restrictions that prohibit them from refinancing and taking advantage of better terms.

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As any loan originator will tell you, 2023 has been a difficult year. And unfortunately, 2024 doesn’t look to be much better. The key to surviving this period will be persistence and a focus on the segments of the market where financing remains readily available, such as multifamily housing and SBA loans for owner-occupied deals.

Using these tools should help you set the table for what will likely prove to be a more opportunistic time once the Federal Reserve has reversed course on its cycle of rate hikes. This will be a testament to Darwinism: Only the strong will survive, and those without the fortitude, experience and ability to excel in a down cycle may find themselves in another field. ●

The post A Continuing Rough Ride appeared first on Scotsman Guide.

ICE reported that September’s national delinquency rate was 3.29%, a gain of 12 basis points from August and up 13 bps from September 2022. The annualized jump was only the second (and the largest) of the past 2 1/2 years, according to ICE.

On a historical basis, loan delinquencies still remain healthy, with September’s rate about 75 bps lower than the level in September 2019, before the COVID-19 pandemic. But beyond the delinquency uptick, other September numbers suggest that the impressive streak of loan performance during the COVID-19 era may be coming to an end.

For one thing, early- and middle-stage delinquencies are growing. Loans at least 30 days past due were up 5.1% from August, an equivalent of roughly 48,800 loans and the fourth straight monthly gain of loans at least one month overdue. Sixty-day delinquencies were up 3% (approximately 8,700 loans), extending the streak of increases for this category to six months.

Serious delinquencies, defined as loans at least 90 days past due, grew to 455,000, although that’s still 6.7% below the pre-pandemic level. The monthly increase was a small one, numbering about 7,000 mortgages. But notably, it’s the first serious-delinquency increase of this year and only the second in the past three years.

Meanwhile, despite the growth in delinquencies, foreclosure activity continues to abate. The number of loans in active foreclosure dropped to 214,000 in September. That’s the lowest number since March 2022 and about 25% below the pre-pandemic watermark. Foreclosure initiations were down by 20.4% in September, ending the month at 25,400. Completed foreclosure sales also fell, sliding 8% from August.

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The first real estate sectors to slump in a bear market are retail and office spaces. As we all know, offices are taking a major hit right now. Go into any large office building in any major city and make a note of all the empty spaces you see. Whether you’re visiting Florida, Pennsylvania, Southern California or Texas, this trend is more or less the same.

Nowhere is the office-space crisis felt more profoundly than in New York City. Edward Glaeser, chairman of Harvard University’s economics department, and Carlo Ratti, the director of MIT’s Senseable City Lab, recently reported that there is nearly 75 million square feet of vacant office space in the Big Apple alone. That’s enough space to fill more than 26 Empire State Buildings.

Repurposed offices

New York isn’t alone. Chicago is estimated to have nearly 60 million square feet of vacant office space, while Los Angeles has another 44 million square feet. This trend appears to be set to continue through the end of this year, making now a good time for interested parties to make low-ball offers on office buildings while continuing to monitor the market closely.

The end of 2023 could prove to be a good time to look at office property investments, so brokers should watch how this sector shifts. For instance, good deals might appear for buildings that go into foreclosure, but caution is appropriate given the current headwinds.

It appears that repurposing may be required to redeem some of these vacant properties. Therefore, mortgage brokers and their investor clients should approach these deals with a plan to add value by finding different, innovative uses for obsolete office space. One idea is to create virtual work pods or coworking spaces with amenities for remote workers.

Repurposing, however, can raise daunting challenges. For one thing, it can be expensive. For another, the many localized permitting processes have made it increasingly complicated to rezone a property for other purposes. Those who undertake a repurposing project need to make sure the zoning is correct for their needs. Otherwise, they need to be confident that they can get the property rezoned.

Some real estate observers have suggested that empty office buildings can be converted into residential units, pointing to the high demand for housing. Unfortunately, zoning regulations may be a hindrance and some of these properties can’t be converted due to underlying architectural issues. Other spaces would be so costly to convert that it wouldn’t make economic sense. As Moody Analytics recently concluded, “The office-to-apartment conversion trend will likely be a minor one, unless office values and rents see some major, permanent decline after the pandemic.”

Housing opportunities

Investors who tackle projects of this nature need to make sure they find people with the right experience who can do a deep, detailed cost analysis and suggest changes that are likely to be lucrative. Not many people have this kind of background. It would also be wise to have plenty of capital on hand. While each project is unique, investors should prepare for a repurposing process to take an estimated one to two years.

According to Zillow, July 2023 rents for all types of housing were 3.6% higher than one year earlier — and it appears that prices will continue to climb. As apartments increase in value, so do their tax assessments, and landlords tend to pass these and other expenses on to their tenants. Plus, the number of available units remains below market demand in many places, while rising mortgage rates have pushed homeownership out of reach for many renters.

For these and other reasons, apartment buildings will continue to be attractive to investors, and they’ll remain a good option for those seeking strong and stable cash flows. In addition, we may see more people look to economize by moving into smaller, less expensive units and by putting things into self-storage units. This is why new construction of self-storage facilities can be a good investment in the near term.

Indeed, new construction of housing, in general, gives investors the ability to make larger returns. This is because tax incentives can help support new construction. Buyers may be able to get their property’s valuation raised after construction, thereby increasing their equity almost instantly.

Farmland option

Mortgage brokers should also be discussing farmland investments with their clients. The nation’s farms offer a promising revenue stream.

The U.S. Department of Agriculture (USDA) reported that the average price per acre for cropland jumped by 14.3% from 2021 to 2022. Average prices in Kansas and Nebraska rose by more than 20%. These price gains are due to numerous factors, including a worldwide food shortage, robust crop prices, inflation and historic government subsidies stemming from the pandemic.

Farmland is an effective hedge against inflation since food prices climb rapidly in times of accelerated inflation. Many investors also believe that commodities will continue to increase in value. The USDA predicts that 2023 food prices will rise at rates above their long-term average.

Acquiring land and vertically integrating within a farm — in other words, owning the farm’s production process and output — presents a valuable opportunity. While it’s impossible to know for sure, some observers believe that the price of farmland will continue to climb through at least 2024.

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Commercial real estate is a constantly changing industry. Investing successfully in such an evolving environment requires constant analysis and frequent adjustments. It also means it’s important to be careful about who you trust.

Mortgage brokers need to direct clients to investments that promise a steady flow of returns regardless of market conditions. A true operator is one who buys under or off market, is always scrutinizing the deal and has a strong flow of potential deals coming in all the time. Whether or not they buy into these deals is based on market conditions.

Projecting two, three, four or even five years into the future is all but impossible. After all, who could’ve predicted the COVID-19 pandemic? What’s easy to see, however, is that buyers need to focus on the right properties in the right locations at below-market prices, in good times or bad. By doing so, anything a client acquires now is likely to grow in value in the future. ●

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That’s according to a survey of more than 50 representatives from leading mortgage servicers and government agencies conducted this past June at the Auction.com Disposition Summit. Ninety-two percent of survey respondents expect their organization’s completed foreclosure volume to increase in 2023 compared to 2022.

What is driving these expected increases? Rebounding roll rates should push more delinquent mortgages into foreclosure status while nudging more active foreclosure inventory into foreclosure auctions.

Survey respondents, on average, expect a 6.4% monthly roll rate from serious delinquency to foreclosure start in the second half of 2023. Applied to the 483,000 seriously delinquent loans (at least 90 days overdue) reported by Black Knight as of May 2023, this would translate into about 30,000 foreclosure starts per month. From January through May, foreclosure starts averaged about 29,000 per month, according to Black Knight. (There were about 527,000 seriously delinquent loans in the first five months of the year.)

The estimated 6.4% roll rate would be an increase from the 5.5% average during the first five months of the year — and well above the average roll rate of 4.7% in 2022. For further comparison, the average roll rate during the pandemic-triggered foreclosure moratorium (April 2020 to December 2021) was 0.4%, while the average roll rate in 2019, prior to the pandemic, was 8.7%.

While the roll rate from serious delinquency to foreclosure start had already started to rebound in the first half of 2023, the roll rate from active foreclosure inventory to completed foreclosure auction remained close to its pandemic-era lows. This rate averaged 2.9% during the first five months of the year, down slightly from 3.4% in 2022 and only slightly above the 2.8% average monthly roll rate in 2021, when the nationwide foreclosure moratorium on government- backed mortgages was still in effect.

According to an Auction.com analysis of data from the Mortgage Bankers Association’s National Delinquency Survey, there were approximately 943,000 mortgages that were seriously delinquent or in foreclosure at the end of first-quarter 2023. That was only slightly higher than the 916,000 loans in these categories as of first-quarter 2019. But foreclosures accounted for only 24% of this bucket in Q1 2023, compared to 44% in Q4 2019.

Moving further down the funnel, 18,000 properties went through foreclosure auction in Q1 2023, representing 8% of the 227,000 in active foreclosure inventory. By comparison, there were nearly 48,000 completed foreclosure auctions in Q4 2019, or 12% of the 406,000 in active foreclosure inventory.

Survey respondents expect an average monthly inventory-to-auction roll rate of 6.6% for the second half of 2023. This would be up from an average roll rate of 2.9% during the first five months of the year and well above the average rate of 1.7% during the foreclosure moratorium. It would also be much higher than the rate of 4.6% in 2019.

If these expectations turn into reality, it could result in a significant uptick in completed foreclosure auctions during the second half of the year. Applied to the 229,000 properties in foreclosure inventory reported by Black Knight as of May 2023, this would translate into about 15,000 completed foreclosure auctions per month — two-and-a-half times higher than the 6,000 monthly average in 2022. ●

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