Commentary Studies & Guides

Banks Positioning for Rising Distress

Banks Positioning for Rising Distress
Photo by Sean Pollock on Unsplash

Commercial real estate is bracing for an increase in distressed loans in 2023, but the situation is dramatically different than the last time the market experienced a wave of defaults, during the global financial crisis.

Debt availability has diminished, and property owners are being squeezed by an increase in commercial mortgage rates, which have increased by 200-400 basis points since reaching historically low levels in the spring of 2022. The average commercial loan coupon increased to 5.3% in the fourth quarter of 2022, up from 3.3% in 4Q 2021, according to CBRE Research.

The Increased Cost of Capital

The increased cost of capital has put some property owners in a pickle, particularly those that took out adjustable-rate low-coupon loans in 2020-21 that either had interest rate caps expire or are up for refinancing and qualify for less proceeds today.

Speaking at a webinar on the state of the debt markets last week sponsored by the Pension Real Estate Association, Chris Tokarski, co-CEO of ACORE Capital, said that distress has already picked up and “more is coming.” Tokarski noted that in recent years some property owners took out interest rate caps that expired before the loan matured, leading to a huge and unanticipated spike in debt-service payments. The index to which floating-rate loans are tied rose more than 400 basis points since early 2022. Other properties are up for refinancing but qualify for a smaller mortgage because of higher rates, lower property valuations and lenders either exercising caution or being out of the market entirely.

Although the number of distressed loans is starting to increase slightly, the situation will intensify as more loans come up for refinancing and rates stay elevated. An increasing number of borrowers are asking lenders and servicers to extend loans, an echo of the “extend and pretend” regime in the wake of the last downturn in 2008-09.

And though loan extensions are happening, Tokarski and fellow PREA panelist Jeff Friedman, principal of Mesa West Capital, noted there are important differences with the GFC. For one thing, before lenders agree to extend a loan today, they typically require concessions such as paying down the loan balance or adding reserves.

The Change in Interest Rates

There are other differences in circumstances, including the change in rates. In 2008, the commercial real estate market was riding high when the economy crashed, prompting property income and interest rates to drop sharply. Friedman noted that the pre-GFC floating-rate index was 5.25% and fell to .10% to .25% afterwards. In that case, the change in rates worked to the benefit of borrowers, as debt-service payments were lower if a loan was extended at the new, lower market rate.

Today’s distress is also related to liquidity, but mortgage rates have changed from low to higher due to inflation and excess demand in the economy. The Federal Reserve is trying to cool the economy, not jump-start it as was the case in 2008.

Another change from the last downturn is that banks’ balance sheets are healthy, putting them in a better negotiating position. Although commercial lending became more aggressive as the last expansion extended past a decade, leverage did not near the aggressive levels of the 2005-07 period and loan defaults have remained relatively low by historical standards. In 2008, the nation’s banking system was on the verge of crisis owing to defaulted residential and commercial loans exacerbated by trading of credit default swaps.

The extent of the commercial distress today is likely to depend on how long interest rates remain high and the impact on pricing, Tokarski said. “If interest rates settle in at 200 basis points higher, cap rates will settle in (approximately) 200 basis points higher,” he said. With values falling and much uncertainty about pricing, the only sales taking place “need to transact rather than want to transact,” Friedman said.

The circumstance has created an opportunity for high-yield capital to fill the gap between the balance of maturing mortgages and take-out loans. Friedman said that such “rescue” capital is plentiful. He said there are other types of loans that continue to get done, such as stable multifamily and industrial properties and recapitalizations of struggling property types such as office.

About the author

Paul Fiorilla

Paul Fiorilla has more than 25 years of experience as a researcher and writer in the commercial real estate markets. He previously served as a vice president of research at Prudential Real Estate Investors in Madison, N.J., where he oversaw publishing of outlooks and thought leadership research. Before that, he covered real estate capital markets and CMBS at Commercial Mortgage Alert.

Add Comment

Click here to post a comment