“The wall of maturities represents a critical crossroads for the commercial mortgage market, impacting both borrowers and originators.”

This impending wall of maturities has far-reaching implications that will disrupt the financial landscape. It will potentially lead to a shortage of financing options, an increase in defaults and a decline in commercial property prices. While this problem is serious, there are strategies that commercial mortgage brokers and borrowers can employ to mitigate the cash-flow and financing challenges that lie ahead.

Looming crisis

This phenomenon of maturing loans within a concentrated time frame arises for several reasons. Key factors include a surge of originations during the low interest rate environment of the early 2010s, a tendency among borrowers to lock in favorable rates with longer maturities, and the cyclical nature of the commercial real estate market.

As a result, these loans are now reaching maturity simultaneously, coinciding with a period of higher interest rates and economic uncertainty brought about by hawkish monetary policy. The wall of maturities represents a critical crossroads for the commercial mortgage market, impacting both borrowers and originators.

With so much market turbulence, looming defaults and few deals transacting, one of the most significant concerns is the valuation gap. Lenders are minimizing proceeds and prospective buyers are seeking discounts for asking prices.

There is little middle ground for borrowers to account for debt-service-coverage ratio stresses, leading to reduced loan-to-value ratios and a potential decline in commercial real estate prices. Morgan Stanley estimates that commercial property values could plummet by as much as 40% from their recent peak, which would have a cascading effect on the industry.

Lender reaction

It’s important to note that the impact of these maturities are likely to vary depending on the type of asset. For example, office properties are expected to be hit harder than industrial or multifamily properties.

Responding to the rising default risks, banks are setting aside substantial provisions for loan losses. This approach could make them more cautious about lending money in the future, creating tighter lending conditions. Even the government-sponsored enterprises, Fannie Mae and Freddie Mac, are likely to be impacted, which will further complicate the refinancing of loans.

In response to the increased risk of default, lenders may impose higher spreads on interest rates and become stricter with underwriting requirements. This will restrict leverage and make it more challenging for borrowers to meet the necessary criteria, potentially exacerbating the financing crunch.

For borrowers, current loans with impending maturities also raise concerns regarding stresses tied to increased escrow and cash-reserve costs. As financing becomes scarcer and more expensive, the strain on borrower cash flow and liquidity adds another layer of complexity to the situation.

Mitigate challenges

Mitigating the cash-flow and financing challenges posed by these impending maturities requires a multifaceted approach. Mortgage brokers should communicate openly with borrowers and offer advice to help them successfully navigate the financial risks while also reducing risk to the lender.

First, consider cash-flow management. Borrowers have begun deferring payments and distributions to investors and equity holders to preserve cash, making it easier to meet other financial obligations. Additionally, selling noncore assets (such as vacant properties or underperforming assets) can help raise necessary funds.

Next is asset optimization. To enhance the value of their properties, borrowers must continually evaluate benchmark data for their respective markets. Making capital improvements to properties can increase their values and make them more attractive to potential lenders. Offering competitive rents, strategic marketing and exceptional customer service can further fortify a property’s position in the market.

The third is debt optimization. The dramatic shift in interest rates calls for a fresh approach to debt optimization. Instead of maximizing loan amounts at low rates, borrowers must focus on minimizing new infusions of equity and limiting capital calls to investors. With today’s higher-for-longer rate environment, as well as general uncertainty for both the short and long term of the yield curve, being proactive is essential as continued rate volatility will keep borrowers on their toes.

Running sensitivity analyses based on the forward curve can help borrowers assess their options effectively. If feasible, borrowers should consider fixed-rate loans with shorter terms or cash infusions to buy down interest rates. If permissible, they can seek to extend terms with their existing lender. The latter approach should be tailored to the loan type and lender, with borrowers presenting a compelling case to justify the extension.

Take action

The key to navigating the situation is proactive planning and preparation. Borrowers and brokers should start taking action now to prepare for the impending challenges. Here are a few steps they can take.

• Seek rescue capital. In some cases, borrowers may need to secure rescue capital or new equity investors. This infusion of funds can help address financial shortfalls and provide a lifeline to properties that face financing challenges.
• Plan and prepare. The impending wall of maturities will arrive swiftly, so planning and preparation are critical for borrowers and brokers. As lenders and servicers grapple with increasingly imminent extension and modification requests, maintaining open lines of communication and demonstrating consistent effort will be essential.
• Be realistic. It is crucial to have a realistic outlook on the future of an asset and the owner’s sources of funds. Loan extensions, discounted payoffs and principal paydown options may not be readily available without a well-thought-out plan.
• Stay informed. With attractive loan options limited, mortgage originators should keep clients informed about terms and rates. Defeasance consultants and third-party specialists in debt markets, hedging and interest rate derivatives can help clients create individualized strategies that take their personal circumstances and risk tolerance into account.

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These oncoming maturities are a critical challenge facing commercial mortgage originators and their clients. The potential consequences, from a drop in commercial property prices to a reduction in lending options, are severe and should not be taken lightly. But with proactive planning and the adoption of effective strategies, mortgage brokers can help borrowers mitigate the risks and emerge from this challenging period with their financial stability intact. ●

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But without accurate data and credible information to determine the catalysts of rising expenses and diminishing revenues, it can be increasingly difficult for a borrower to discover the value of a property. It is equally likely that the cause of decreasing cash flow is either internal or external — or a perfect storm of both.

Commercial mortgage originators can help borrowers find their way to better data analysis by introducing them to and helping them understand the value of commercial property performance benchmarks. In any trade, a gauge is vital to consistently produce the highest-quality observations and results. In the commercial real estate space, benchmarks are among the most useful tools to measure the performance of real assets.

Originators can work with their clients to pull data and interpret results. With the answers in hand, operators can develop an optimization strategy and all parties can confidently move forward with financing efforts.

Benchmarking properties

Real estate benchmarks consist of external property data associated with various measurements, including market rents, occupancy rates, operating expenses and net operating income. This data is collected from management teams for assets across a range of sizes, features, locations and classes.

The data is then organized and analyzed to identify trends and typical benchmark ranges. Owners can compare the benchmarks against their internal property data, with the results helping them to identify areas of operational improvements or strategic changes to maximize market trends. The subsequent decisionmaking tree will differ depending on the answers and the principals’ objectives.

Benchmarks, however, are beneficial for more than asset optimization. They are indispensable in assessing the value of a single property or portfolio in the acquisition, refinance or disposition processes. They can also help to narrow the bid-ask spread and identify value-add opportunities. During times when valuations are in flux, benchmarks can help borrowers get a better idea of a property’s true value.

Property performance benchmarks have been around for years, but the size and quality of these datasets have grown substantially due to recent technological innovations. Organizations such as the Institute of Real Estate Management, the National Apartment Association, and the Building Owners and Managers Association, regularly collect and report data tied to commercial real estate, including multifamily, office, industrial and other types of assets.

Collection and analysis

Benchmarks do not offer much utility unless operators possess quantitative data to understand the performance of any properties to be acquired and can then compare this information to marketwide data points. Gathering this external data, however, can take significant time and labor. It requires coordination between management teams, especially when the owners are benchmarking a portfolio of assets.

Once the information is assembled, it can be analyzed to prepare the necessary data points for comparison. For assets or portfolios on a midsize or large scale, this analytical work requires specialized expertise. Therefore, whether hiring internally or contracting with third parties, the retention of data analysts (or data scientists for more complex portfolios) is a prudent move to draw the needed points and conclusions from the raw datasets.

This is an area where innovation can create greater efficiency, clarity and results. Industry-specific data and asset management platforms connect all systems or silos where data is housed. They automatically aggregate, organize and analyze the data, then report the key performance indicators (KPIs) and insights. While it’s not a substitute for seasoned analysts and decisionmakers, technology can significantly streamline the benchmarking and optimization process.

Competitive sets

With internal data for their own properties in hand, the next step for operators is to identify the groups of external assets for comparison, aka “competitive sets.” Comparing owned asset data to that of a properly assembled competitive set allows a borrower to objectively view the value of their properties and how they’re performing relative to the rest of the market.

For instance, if internal revenues are down year over year but are on par with the rest of the market, this provides a clue that the property is being well run and any change in value may be tied to external factors. Conversely, when these metrics fall short of market averages, it can signify that attention is needed internally.

Determining which properties comprise the competitive set is an important component of the benchmarking process. While the perceived sets are typically those with similar superficial characteristics (i.e., asset type, location or size), the actual set may include properties with similar operational parameters that can be statistically identified. Mortgage originators should seek out team members or advisors with experience in collecting and analyzing benchmark data and grouping it for effective comparisons.

Once the competitive set is defined and the data is prepared, the owner or asset manager can then determine how the property compares with similar assets from a revenue or expense standpoint. If the property is in the top quartile across the board, it is doing pretty well. But if it is in the bottom quartile, it is clear that work needs to be done.

Key indicators

Owners and operators should concentrate their attention and efforts in areas where they can influence results. Some data points or KPIs to look at on the income side include net effective rents, gross rents, rent adjustments, and losses or gains to lease rates. In regard to outflows, it pays to compare management costs along with the expenses of leasing, utilities, insurance, taxes and maintenance.

Revenue as a percentage of operations is a crucial measurement and a high-level point of comparison. It is valuable to know by what percentage revenues exceed or fall short of expenses. Expense ratios are another critical group of metrics to evaluate in the controllable expense line.

Another important benchmark is to look at the level of cumulative or specific expenses that are being consumed as a percentage of the gross operating income. The analysis will let a borrower know whether the property is being managed efficiently, and if the geographic market is favorable in terms of typical operating costs that are influenced by location-specific variables such as taxes, materials and labor.

In addition to providing the basis for assessing the performance of a particular asset, market lease rates and occupancy metrics help owners understand the strength of the subject market and other geographic areas. The data points uncover how much upward potential there may be for rent increases, and they are instrumental in the due-diligence process for acquisitions.

Strategy and decisionmaking

Commercial mortgage originators need to keep in mind that the purpose of this entire process is strategic planning and decisionmaking. Whether for optimization, acquisition, disposition, refinance or other initiatives, benchmarking equips the broker and borrower with knowledge of where an asset or portfolio stands in respect to the broader market.

For each of these objectives, a strategy powered by technological innovation and management is best served by the insights gained through benchmarking. Knowing the KPIs through internal benchmarking and comparing them to the market as a whole creates a starting point for finding both problems and solutions. But from there, a framework is required to efficiently plan optimization efforts and align team members across an organization with a clear vision and unified approach.

An ideal framework for using this new information is objectives and key results (OKRs). These are tools used by companies to set goals and create the steps to reach them. OKRs encompass key performance indicators, which can be used to measure the results of how the company did in achieving its set goals. This process is complex, but there are many resources available to plan and implement an OKR-driven strategy.

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The U.S. economy is testing the resolve of all stakeholders in the commercial real estate industry, with property owners and potential buyers positioning themselves to take advantage of this time of fluctuating values. Benchmarks are both a ruler and a compass that equip commercial mortgage originators and their clients with tools to navigate murky market conditions. They’ll be more likely to gain a true sense of direction in their pursuit of stability and growth, despite the upswells in mortgage rates and expenses. ●

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When evaluating a potential borrower or supporting a current lender, mortgage brokers who offer advice on leveraging widely available and cost-efficient technology can help ensure their ability to meet debt-service requirements and contribute to a lower lending risk. For instance, there are technologies and strategies to monitor, control and optimize operating expenses. These include tracking of property costs, management of building maintenance and improvements, and optimization of energy and water consumption.

“Asset, data and project management platforms can be used to automate tasks, help team members interact seamlessly and find important information quickly.”

Commercial mortgage originators can reduce lending risks, avoid bad deals, support the success of their clients and build lifelong relationships. This is possible by evaluating and advising new and repeat borrowers on tech-enabled strategies to control expenses and increase positive leverage.

Tracking and benchmarking

When values are rising and rent growth is strong, owners don’t have to work too hard to generate margins, deliver returns and keep their leverage positive. Fast forward to today as interest rates are well above the historic lows of 2021. Capitalization rates are rising and pushing down valuations as rent growth has cooled.

At the same time, inflation has slowed but is still swelling. This translates into higher operating costs, higher vacancy rates and more competition for tenants, as well as additional pressure on purchase, development and refinance candidates.

Property owners must be more mindful and proactive in controlling and optimizing expenses to stay in the black. To accomplish this, they must first develop an awareness of cash inflows and outflows. Once expenses are known, asset operators need a basis of comparison to determine if and by how much expenses exceed the norm. In other words, how do their properties compare to similar types of assets? These are two purposes for which technology creates cost and time efficiencies.

“The ability to ensure that a commercial real estate company remains a leader over the long term by leveraging innovation throughout its project life cycles assures growth and solvency well into the future.”

Web-based data management software can collect expense and income data from assets across a portfolio. Some specialized platforms also integrate external benchmark data to provide operators with dashboards that display expense data by category. This allows borrowers to compare their assets side by side with data for comparable assets. This insight and frame of reference allows operators to pinpoint where expenses need to be optimized and by how much. Budget or labor cuts can be arbitrary without data to inform decisions, and they may not produce the intended outcome.

Integrative technology isn’t mandatory. After all, an operator could have each property management team assemble and submit data via spreadsheet or PDF. But the unnecessary labor expense and delayed information can hinder a property owner’s profits, margins, situational awareness and ability to make timely decisions.

Mortgage originators need to explain to clients that a commitment to innovation as a value proposition is a major draw for investors and tenants. The ability to ensure that a commercial real estate company remains a leader over the long term by leveraging innovation throughout its project life cycles assures growth and solvency well into the future.

Automating processes

Management functions are typically significant expenses for commercial real estate operators. The labor required to screen and interact with tenants, collect rents, prepare rent rolls, complete leases and maintain books adds up to a substantial amount of money and time. On top of these chores, staff must complete many other tasks, such as compliance, data collection, and analysis and reporting of results.

While no one is advocating for fewer jobs, technology offers the opportunity to streamline and automate many tasks that introduce bottlenecks and occupy staff members with busywork. Individual and organizational productivity improves when team members focus on work that more directly contributes to increasing revenue, such as sourcing acquisition opportunities, improving tenant satisfaction, strategic marketing and more.

When a property company can use enhanced productivity and efficiency to scale up, more work opportunities are created for the community. Asset, data and project management platforms can be used to automate tasks, help team members interact seamlessly and find important information quickly. The technology can also help organize their efforts, bolstering productivity and generating greater net operating income.

Managing the property

Keeping facilities energy efficient and in top condition are additional areas where technology offers support. On the front end of the development cycle, as well as when planning improvements, software programs such as building information modeling (BIM) can be used. This modeling tool helps stakeholders visualize various aspects of the future project, including everything from how the building will operate, serve users, and consume energy and water.

When the project is complete, facilities management (FM) platforms help track utility usage, user behavior and maintenance requests. Automated building data collection, monitoring and reporting — as well as online tools where tenants can self-schedule service requests — help management and maintenance staffs work more quickly, understand property conditions in real time and control costs.

Mortgage brokers can show clients how BIM and FM, in conjunction with asset and data management systems, provide greater perceived and actual value to stakeholders. This is particularly true of tenants and lenders that appreciate transparency, up-to-date insights, convenience and pass-through value.

New systems can be installed to minimize waste and long-term operating costs for newly constructed, renovated and redeveloped assets. Utilizing sustainable building materials and design strategies can also contribute to reducing water and energy consumption. Moreover, sustainable design technology promotes healthy building conditions, such as air quality and thermal comfort. These factors promote physical and mental well-being that fosters tenant loyalty, top-of-market rents, low vacancies and community goodwill.

A big plus provided by sustainable technology on a project’s maintenance side is durability. Part of what makes a material or design approach “green” is the capacity of the finished product to withstand years of wear and tear due to typical usage and environmental conditions. Leveraging durable materials significantly reduces planned and unexpected capital expenditures while extending the project’s useful life and marketability, including its appeal and demand.

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In the current economic environment, it’s prudent and crucial to survival for commercial mortgage borrowers to leverage the most innovative technology available to maximize profits and keep a competitive edge. As the competition for tenants gets tougher due to ample inventories of vacant space and downward rent pressures, owners and operators must concentrate on efficiency and optimization to meet the repayment expectations of lenders and investors. Mortgage originators can help clients find success in the current commercial real estate environment by advising them on the potential and promise to be found in the latest technology advancements surrounding automation and property management. ●

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“With a complete data set that’s pertinent to stated objectives, borrowers can drive growth, manage risk, and position their assets and portfolios to weather any economic conditions or unexpected risks.”

Market and property data are essential for strategic decisionmaking that contributes to the lasting strength and upside of the investment. But how does a borrower in search of the right asset find the data to help them make wise decisions? Understanding data and how to find it are skills that commercial loan originators will find invaluable when it comes to meeting the needs of clients and helping them develop a stable and growing portfolio.

Planning ahead

It is often crucial to understand where borrowers stand operationally and financially to help guide them through a successful deal. Commercial mortgage brokers must be aware of market conditions — including threats, opportunities and monetary policy. They must also know about asset performance (owned and comparable assets) as well as the client’s strengths and weaknesses.

With a complete data set that’s pertinent to stated objectives, borrowers can drive growth, manage risk, and position their assets and portfolios to weather any economic conditions or unexpected risks. Data fuels analyses and projections, and it promotes objectivity when conducting stress tests for various scenarios or developing contingencies for possible outcomes.

During the due-diligence process in preparing to acquire, refinance or dispose of an asset, brokers require data to calculate a property’s value. This includes finding experienced appraisers who are familiar with the areas where the properties are located. Beyond the basic process of property pricing, brokers also need to help clients understand market fundamentals and property performance characteristics that contribute to fair market values.

Such insights facilitate forward-looking strategic planning rather than merely guaranteeing a good deal upfront. Market and asset performance data also ensure the geographic region and asset type being considered have the potential to foster returns throughout the anticipated life cycle of the investment.

Knowing the property value indicated by the data also helps in negotiations and may narrow the bid-price versus asking-price gap. Both parties to the transaction can test their assumptions and present evidence to support a value that will facilitate a prompt, confident and mutually beneficial closing.

Vital data

Whether buying, refinancing or selling property, data can help to reposition assets and maximize their value. Borrowers can see where expenses are creeping higher along with any shifts in lease rates or rent prices. This information can help them make better decisions.

They can also look at benchmark data to see how similar assets are performing, then compare them to the property in question. This information can aid in planning justifiable strategies to boost their net operating income and property value. The data is important to not only conclude a deal with the most equity possible but to also leverage capital for subsequent loan originations.

It is obvious that data is crucial for business success. Although intuition has a place, reliable decisions require a broad sample size of relevant data. Fortunately, data is abundant, and when commercial real estate buyers and sellers know what to look for and where to find it, they can assemble information to analyze most aspects of the operational environment. There are a wide variety of data types and sources available to mortgage brokers and their clients.

Sources to consider

The following are some examples of where to find information or where to learn how to gather the information needed to make the right decisions. These include benchmark asset performance data sets that can be found through the Institute of Real Estate Management, which offers information such as its Income/Expense IQ reports that cover property financial data. Other groups that offer asset performance data on commercial real estate sectors include the National Apartment Association and the Building Owners and Managers Association International.

Excellent sources of quantitative market research are available in trade publications, as well as reports generated by research and analysis firms like Green Street, Cushman & Wakefield, IBISWorld and the National Association of Convenience Stores, just to name a few. Other sources include anecdotal and data-based evidence from notable economists, executives and other thought leaders who contribute to conferences, trade publications and newspapers.

Transactional data is also available from data aggregators such as CoStar, Reonomy and CoreLogic. There are listing sites such as LoopNet, which is part of the CoStar group of real estate sites. Sources for tax and public records include the offices of county assessors.

Don’t forget about the big picture when looking for information, including demographics and behavioral trends. This type of data can be gleaned from the U.S. Census Bureau, the U.S. Bureau of Economic Analysis and other government agencies. Other sources include private research groups and academic institutions — such as the Institute for Research on Poverty at the University of Wisconsin, which offers links to demographic and socioeconomic data across states, counties and cities.

There are many other types of data resources that may be most relevant for an individual borrower’s situation and objectives. Therefore, brokers should consult with other professionals specific to the markets and asset types their clients are involved with. These people can help to identify appropriate data sources and make the connections required to access them.

Practical application

With the wealth of data and sources available, there is the potential to get stuck in a multitude of data points that overwhelm the investor. Additionally, the best data in the world will not provide significant benefit unless it is transformed from raw information to usable knowledge under a comprehensible format.

Unless the broker or borrower are trained analysts, or have deep experience in their fields and across functional areas and data types, they may not be adequate for generating timely and accurate insights. When this is the case, retaining expert advisors and analysts is worthwhile and generally prudent. Two ways to go about this are to build an in-house team or to bring in consultants.

Developing an internal data collection and analysis team may be a suitable strategy if the investor or operator has the time and budget. But contracting out may be preferable if time and money are limited, such as when a deal is on the table. In either case, ensure the advisors and analysts hired know the market and asset type in question.

Whether working with an internal or external team, a system and specific processes are required for efficiency and accuracy. Data and asset management tools, including tailored software for the asset type and purpose, may provide a cost-effective solution.

Current technology facilitates the aggregation, organization and interpretation of data. Rather than digging through mountains of data, manually breaking through silos or logging numerous hours of labor, commercial real estate companies can leverage technology to eliminate such barriers without excessive expense or an extended learning curve. Once the data is laid out logically and interpreted by analysts, a broker’s clients can create plans and make decisions that account for known variables and likely outcomes.

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With the right data in hand, commercial mortgage brokers and borrowers can feel confident that the decisions they make are the wisest and most informed. The best choices are based on well-developed situational awareness achieved through organized data collection, analysis and reporting. ●

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In other words, borrowers need a hedge to protect themselves. In commercial real estate finance, interest rate caps and swaps are tools to mitigate the borrower’s risk. Mortgage brokers should be aware of the market factors that signal the need for hedging and understand why it’s a crucial strategy to manage exposure. They must be able to explain to their clients how methods such as caps and swaps work and offer tips for assembling a hedging plan.

“Conventional and natural hedging techniques include diversification of asset types, favoring equity over debt, timing the market for more favorable circumstances and betting on rent growth during times of inflation.”

Interest rates have increased as the Fed has tightened monetary policy over the past year. It was the most aggressive period of monetary tightening in more than 40 years, with a total of seven rate hikes, including four consecutive 75 basis-point increases. At the end of 2022, the federal funds rate stood at a target range of 4.25% to 4.5%. In February 2023, the Fed added an increase of 25 basis points, and the tightening is expected to continue but at a more gradual pace.

As rates have increased, so have lending costs and capitalization (cap) rates, which translate to higher risk. When financing costs and perceived risk increase, investors demand higher rates of return to offset the exposure. Consequently, as cap rates rise, valuations fall. And when the cost of borrowing exceeds the rate of return, negative leverage occurs.

According to research from Moody’s Analytics, 30% of commercial mortgage-backed securities loans exhibited negative leverage in third-quarter 2022 due to the rapidly rising costs of financing and relatively low cap (return) rates. Some borrowers are entering deals aware of negative leverage and hedging their bets on rent increases (a natural hedge). Their hope is that rising rents will gradually increase the net operating income (NOI) and rate of return to outpace the growth of debt service on floating-rate instruments.

With the current economic conditions, however, the degree of certainty that anyone can anticipate the market’s movements over the next several years is very low. Therefore, borrowers need additional interest rate hedging strategies to ensure long-term positive leverage, NOI growth and solvency.

Commercial real estate finance is inherently risky, yet experienced lenders, brokers and borrowers can prevail under most economic conditions with the appropriate tools. Hedging is a prudent strategy for many investments and is often lender required. When a broker’s clients are buying real property, hedges reduce the risk to individual assets and portfolios, as well as business and personal credit, by preparing for worst-case scenarios. Hedges essentially act as economic insurance.

Formulating strategy

It’s best to develop a hedging strategy early in the process of negotiating a deal because it is hard to switch course later. There are many variables and considerations in choosing a hedging strategy, so it’s best for investors to consult a qualified and experienced commercial mortgage originator and hedging advisor while in the planning stages.

Here are some reasons that borrowers and originators should consult a hedging advisor:

• Hedging approaches and products can be very complex.

• They’ll need help understanding the various documents and processes that are involved.

• Soliciting contract bids from multiple counterparties will result in the best execution.

Only the borrower, with the aid of their mortgage originator or hedging advisor, can make the call as to which hedging strategy is correct. Some combination of natural hedges and derivatives will work for most investors and their deals. Several variations of each derivative type are available, and one may best suit the borrower’s unique transaction and objectives.

Risk management

Conventional and natural hedging techniques include diversification of asset types, favoring equity over debt, timing the market for more favorable circumstances and betting on rent growth during times of inflation. With increasing costs of funds, raising as much equity as possible is sensible and sometimes necessary. Loan-to-value limits have tightened as lenders have become more conservative.

Borrowers also can delay development, acquisition or refinance plans until conditions are more favorable. These plans may not always be practical, however, if high expectations of growth and returns by investors demand action before economic factors are ideal. Moreover, the Fed isn’t likely to change direction anytime soon, so the grass may not be greener for years.

In the multifamily housing market, for example, rent growth has been a reliable hedge for commercial real estate owners as demand for units has caused valuations to soar. But with inflation restricting consumer and business budgets, and development activity catching up, rent growth has started to slow.

According to Realtor.com, U.S. apartment rents were up 3.4% year over year this past November, the smallest increase in 19 months and the 10th month in a row that annualized rent increases had slowed. Consequently, rising rents aren’t something that owners can count on to prevent negative leverage.

Use of caps

Each of the following approaches are valid, but the practicality and degree of protection offered by them may not be enough to make a deal feasible in an environment of rising rates and diminished returns. Property derivatives (which allow investors exposure to real estate by replacing the properties with the performance of a real estate return index) are an alternative solution to bridge the gap, preventing financial stress and default risk when rates rise. Caps and swaps also are used by creating a hedge through a derivative contract.

An interest rate cap is, fundamentally speaking, an insurance policy against rising interest rates. It is a limit on how high the interest rate can rise on variable-rate debt. It is tied to a short-term index such as the Secured Overnight Financing Rate (SOFR).

The interest rates on a large portion of commercial real estate loans are variable, so that when rates increase, so do debt-service payments and total financing costs (potentially pushing the asset or portfolio into negative-leverage territory). Rate caps create a ceiling that the interest rate cannot exceed. Once the interest rate exceeds this cap, the counterparty (a lender or a third-party hedge provider) will reimburse the borrower the difference between the current index or reference rate and the cap. The borrower still makes the principal and interest payments as stipulated by the original note on the asset.

To mitigate the risk of the rate rising above the cap, the counterparty requires a premium or upfront fee. In a rising rate environment, the cost of a rate cap can be high, but it is often well worth it to protect the solvency of the project. In summary, the primary advantage of an interest rate cap is that borrowers are shielded against substantial interest rate increases and can even benefit when rates fall. Conversely, the key disadvantage is that obtaining a cap agreement requires an upfront cost that can impinge liquidity at the outset of a deal.

Use of swaps

Another derivative instrument is a swap, which involves a derivative contract between the borrower and a counterparty to substitute a floating rate for a fixed reference rate during the term of the agreement. The swap rate is a fixed interest rate to be paid by the borrower.

In this arrangement, the counterparty will pay the floating rate to the borrower and the borrower will pass this onto the lender. The borrower will then pay the fixed rate to the counterparty. The counterparty adds its premium into the rate so that the borrower pays it over the life of the swap contract. The borrower does not pay an upfront premium, but depending on the relationship with the counterparty, the borrower often must post collateral.

The borrower will benefit when floating rates rise above the fixed rate, but they may lament entering the swap agreement if rates decline. To ensure the borrower continues to honor the contract, they typically must pledge collateral. If the borrower chooses not to uphold the swap, the counterparty can claim default and require a termination or buyout, and breakage or prepayment penalties will be due.

Swaps offer an alternative approach to interest rate risk protection with no upfront costs, allowing investors to conserve cash and move forward with confidence. The primary downside is that swaps are less flexible if the borrower opts to make an early exit from the asset or note, often as a response to declining rates.

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With an awareness of the capital markets, monetary policy and finance hedging techniques, borrowers and originators can confidently proceed with transactions. When a deal initially looks like the numbers don’t make sense, dig into due diligence, do what’s possible to raise additional equity, and research the available hedging techniques and products. This will provide a solution that brings economic risk to manageable levels and magnifies the upside for all parties to the transaction. ●

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While meeting the expectations and objectives of investors is important, lenders also derive practical benefits from working with ESG-centric borrowers.

ESG defined

The trend toward environmental, community and operational sustainability is causing borrowers who are more reliable, productive and equipped to flourish.

Gaining popularity

Creating value

Reducing risk

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Collect wisely

Silo obstructions

Targeted tools

Simple and practical

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Basic concepts

When the yield curve flattens or inverts, it is crucial for mortgage brokers and other finance professionals to act as the borrower’s guide, assisting them in securing a loan that will minimize their financing costs and economic risk.

Imminent recession?

Volatility ahead

Responding to change

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Rising trend

Environmental initiatives

Through this refurbishment process, commercial mortgage professionals and property owners are enabling these structures to serve their highest and best uses while delivering a greater upside to tenants and lenders.

Potential hurdles

Adaptive reuse comes with its share of development and financing challenges. In a 2018 report, the CCIM Institute highlighted many challenges of adaptive-reuse projects, including:

• Limited collection and reporting of metrics that would help participants understand certain factors, such as the impact of renovation projects on a local community

• Permitting and zoning issues

• An absence of an industry-recognized methodology for underwriting and valuation tasks

• High risks that may turn away institutional investors

Developers also may discover pollutants such as asbestos or lead paint on-site once work has commenced on a project. The resulting mitigation delays and cost overruns are more reasons why developers need to conduct thorough due diligence before plunging into these types of rehab projects.

Funding sources

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As investment vehicles, these last-mile warehouses should catch the attention of commercial mortgage lenders, brokers and investors. There are a number of inventive ways to finance these projects.

While the COVID-19 pandemic has been a difficult time for most business sectors, one area of the U.S. economy, e-commerce, has continued to reach new heights. At a time when many people have been working from home and avoiding physical retail spaces, they have been increasingly turning to online shopping for nearly all of their needs.

This habit appears to be continuing even as vaccines, masks and social distancing have lessened the pandemic’s grip. But such success has resulted in a difficult logistics problem: Not only have consumers grown to appreciate the choices and convenience that e-commerce offers, they also expect to receive items almost immediately.

Retailers big and small are rising to this challenge. They’re finding new ways to diversify their inventories and bring goods to consumers more quickly — including many same-day services. These changes are creating new opportunities for investors who are thinking about diversifying their commercial real estate portfolios.

Current needs

Of course, the “click over brick” phenomenon in retail has been going on for years. But the pandemic has sped up this transition by forcing many people to avoid stores out of necessity. Consumers have grown accustomed to having an endless selection of items at their fingertips. Even consumers who are now returning to malls and big-box stores are still frequently buying online since they can expect to receive their orders within 24 to 48 hours — at no extra cost.

This shift in consumer behavior presents unprecedented challenges for retailers. To meet consumer demand, distribution warehouses need to be large enough to accommodate growing inventories, but they also must be close enough to where consumers live to allow for packages to be delivered at an increasingly faster pace.

Unfortunately, older warehouses and complexes are not always a good fit for the demands of the modern supply chain. Many of these facilities are built to dispatch large amounts of cargo along fixed routes. They tend to be located in rural areas, offer limited shipping docks and have low ceilings that are often unsuitable for modern vertical racking systems. What is needed are innovative, last-mile industrial facilities to quickly handle smaller items and diverse inventories.

Urban landscape

Finding the space to build appropriate warehouses has become a major headache for e-retailers. Large parcels of land that are close to urban centers, include abundant parking and have easy access to shipping routes are scarce and expensive. Additionally, such properties are often subject to competing offers from other buyers.

Given the limited supply of these resources, e-retailers have been seeking inventive solutions to repurpose existing facilities. Empty shopping malls and defunct industrial facilities have been two primary sources. Some big-box stores have opted to reconfigure their existing retail spaces to accommodate in-store distribution facilities where customers can pick up online orders.

Retailers also have turned to more unexpected sites, such as an abandoned naval base in Bayonne, New Jersey, and a mammoth underground parking garage in Chicago. With a growing number of people working from home for the foreseeable future, office buildings could be the next target. And some retailers are considering building additional stories on their last-mile industrial complexes to maximize utilization of the footprint.

All of these conversions and developments are transforming the urban landscape in various ways. This includes the revitalization of neighborhoods through new jobs, the redevelopment of obsolete or underutilized retail properties (greyfields), and the cleanup of toxic waste from former industrial sites (brownfields).

Self-sustaining growth

The changing ways that we shop, and our increasing expectations for fast delivery services, are awakening investors and lenders to a new reality. Capital sources understand that last-mile industrial complexes are the most in-demand assets to fulfill growing consumer and business needs.

According to commercial real estate services company Cushman & Wakefield, the demand for warehouse space pushed U.S. industrial rents to a record high of $7.03 per square foot in second-quarter 2021, marking a 6.8% year-over-year increase. Similarly, the vacancy rate of 4.5% at this time was lower than it was 10 years ago, while construction was underway to add another 476 million square feet of industrial space nationwide (and 36% of it was already preleased).

Efforts to build and transform underutilized spaces into distribution facilities that fit with the 21st century are helping to accelerate the economic recovery. What’s more, establishing last-mile industrial facilities creates jobs, many of which are located in economically distressed communities.

Related sectors — including logistics, manufacturing and construction — are benefiting from this ripple effect as they help to meet the demand for more space. And the research and development sector is creating innovative ways to help last-mile facilities be more efficient, including through the use of self-driving vehicles, drones and other logistics solutions.

Project financing

Despite all of the upside, the creation of last-mile industrial facilities presents financial challenges. It’s often a cheaper solution to refurbish existing structures and sites than to build new facilities from scratch, particularly given the rising costs of both materials and labor. Still, the scarcity of suitable locations, coupled with the need to adapt older buildings to the demands of modern e-commerce, lends credence to investing in new developments.

Industrial properties are in high demand and availability is limited across the country, resulting in expensive bidding wars in which investors often come ready with all-cash offers. Commercial mortgage lenders, however, are typically solicited in post-closing periods to refinance projects or fund construction efforts.

At the same time, commercial mortgage brokers are competing with joint ventures to finance last-mile industrial complexes. Lenders are working with brokers to secure developers by offering low interest rates (below 3% in some cases) and other attractive terms. They also are considering lower capitalization rates (3% to 4%) in gateway markets such as San Francisco, Los Angeles and New York City.

The ongoing market restructuring has catalyzed this race and has reinforced the urgent need for these assets. As things currently stand, these developments are considered secure and lucrative investments. The assets offer the advantages of low vacancy rates, long-term leases and tenants with strong credit.

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The pandemic dramatically accelerated trends in consumer behavior that were growing for the past decade. Consumers want everything — and they want it now.

This surge in demand has forced e-retailers to get creative with last-mile industrial sites that offer the security of long-term tenants and stable investment returns. Investors and lenders are doubling down on this niche market to meet intense demand, and mortgage brokers also stand to benefit from this growth as retailers of all types embrace the online shopping experience. ●

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