With interest rates at a 16-year high, the current high cost of capital has created levels of distress in the Commercial Real Estate market not seen since the 2008 Global Financial Crisis. Developers and commercial real estate investors face challenges in securing financing for new projects, refinancing existing loans, and increasing risks of default. These challenges have slowed down transaction volumes dramatically and increased the number of distressed properties across the country.
During this time of market distress, it is helpful to look back to the 2008 Global Financial Crisis. Institutional lenders, regional banks, and commercial lenders faced a similar dilemma then as they do today, including calling defaults, foreclosing, and taking their losses now or, in the alternative, modifying interest rates, extending maturity dates, and betting that property values will rebound over time. In 2008, banks often chose the latter since banks are in the business of lending, not owning and leasing property, hence banks’ aptitude for loan workouts. Their preference for loan workouts was due in part to Federal Reserve guidance (See FRB SR 09-7). In 2009, "Federal bank regulators issued a policy statement that allowed banks to keep loans on their books at full value in many situations even if the property backing the loan was worthless than the loan balance." (Commercial Property Debt Creates More Bank Worries, WSJ) So, instead of calling defaults or selling loans, banks simply extended maturity dates and reduced interest rates through loan workout programs to preserve the value of their collateral. Critics called it the "extend and pretend" strategy, but banks effectively spread out the financial distress from the 2008 Global Financial Crisis over a period of several years, instead of a concentrated moment in time. Many nonÂperforming loans from 2008 were still being modified and extended well into the 2010s. "While banks had a reasonable expectation of being repaid, critics warned at the time that this guidance would hurt the economy in the long run because the pain was only being deferred." (Commercial Property Debt Creates More Bank Worries, WSJ)
These same incentives for banks to engage in loan workouts exist today. 2023 has seen bank runs and regional banks suffer large losses on their commercial real estate loan portfolios. According to an analysis from Trepp Inc., "small banks are holding approximately $2.3 trillion in commercial real estate debt, which accounts for almost 80% of commercial mortgages held by all banks." (Commercial Property Debt Creates More Bank Worries, WSJ) Many office properties have lost value during the pandemic era due to new remote and hybrid workplace strategies adopted by business tenants. Also, according to Trepp Inc., this year will be critical as about $270 billion in commercial mortgages held by banks are set to expire, which is the highest figure on record, and most of these loans are held by banks with less than $250 billion in assets.
With the 2008 Global Financial Crisis as a guide, the market should expect to see many loan workouts over the course of this year and into the next. Loan workouts make commercial real estate distress a long game by buying banks and developers the time for the interest rates to go down and property values to rebound. However, commercial real estate distress is a short fuse, and banks, developers, and commercial investors should engage counsel early and begin communication with one another before default becomes imminent and unavoidable. By involving (competent) attorneys early on, banks and borrowers can mitigate risks of default and foreclosure, preserving property values by allowing recovery over a period of time.
