4 Things To Watch As Office CMBS Debt Matures Next Year
Tens of billions of dollars in commercial mortgage-backed securities for office buildings in the largest U.S. cities will come due by the end of 2024, and lawyers say there are more questions than answers for a sector that’s in flux and facing various economic headwinds.
Upwards of $16 billion in office-backed CMBS debt in New York alone will come due by the end of next year, according to data from Trepp, while properties in San Francisco, Los Angeles and Chicago will each see roughly $4 billion to $5 billion in loans come due.
Refinancing, experts say, will be challenging — partly due to the recent spike in interest rates. But more concerning could be a lack of clarity on what the new normal for brick-and-mortar office use will be, given such a large percentage of the workforce continues to work from home, more than three years after initial COVID-19 lockdowns sent shockwaves throughout the office sector.
“There are general questions on each loan. We’ve had a bunch of these that we’ve been working on,” said Robert Ivanhoe, vice chair of Greenberg Traurig LLP. “I wouldn’t say it’s been a flood. There are way more ahead of us than what’s behind us.”
As there’s a large chunk of CMBS office debt coming due, default rates are also starting to tick up. In May, the delinquency rate for CMBS office debt shot up to 4.02%, crossing the 4% threshold for the first time since 2018, according to a June report from Trepp. The overall CMBS delinquency rate as of May stood at 3.62%, below the 4.02% mark for office loans.
Here, Law360 looks at four things to watch as this CMBS debt comes due over the next year and a half.
Parties Are Waiting for the Next Cycle
Rather than lock in long-term refinancing at current interest rates amid an uncertain future for the sector, many borrowers are looking for short-term solutions to buy themselves a couple of years to reassess.
“What everyone’s looking for is a minimum of two to three years to get through this trough, and at the end of two to three years, then we’ll see if we’re really on the other side,” Ivanhoe said. “If the loan is in default, it’s much harder to do that.”
That short-term approach, which might involve a forbearance period or a bridge loan, can also be attractive for lenders who aren’t necessarily interested in owning an office asset if the borrower defaults.
“Banks are going to be very reluctant to take them back. There’s going to be a valuation adjustment. It will be different in different cities,” said Andrew Raines, a partner at Raines Feldman LLP. “With that reset, then we will start in that new cycle.”
Indeed, the current environment brings back memories of the early 1990s, when the U.S. was in a mini-recession, Raines said.
“Stay alive till ’95. That was the mantra,” Raines said. “When in periods of adjustment like this, the real estate community realizes it will take a little bit of time to wait for conditions to change.”
Underwriting Is Changing
While waiting for one, two or three years to lock in long-term financing may gain borrowers a lower interest rate and more clarity, borrowers now and down the road will likely be up against more conservative underwriting on the part of lenders, lawyers say.
“Getting refinancing is very challenged by the difficulty of the underwriting going forward on a new loan. The underwriting standards are very different,” Ivanhoe said. “The rating agencies are very negative on the future outlook of office, and they’re really making very significant [changes] in how they’re underwriting a new loan.”
One way underwriting is changing is on the question of how banks look at leases. With less rental income coming in due to higher vacancies and in some cases lower rents, lenders are more skittish to provide new loans.
“Lenders themselves have their own issues with respect to the amount of loans that they can make,” Raines said.
Loan-to-value ratios, Raines said, are also getting more conservative, meaning lenders won’t allow borrowers to have as much debt as they may have before the start of the COVID-19 pandemic.
“The metrics in the underwriting will be much more severe. Lenders are much tougher if it’s a monetary default [versus] a maturity default,” Ivanhoe said. “If it’s a default, it’s very hard to do a serious restructuring.”
Additional Equity or Mezzanine Financing May Be Needed
Given a softening of real estate prices and high interest rates, borrowers may find they need to put more of their equity into the loan or look for an additional capital provider to come into the capital stack. And while such additional financing often comes at a high interest rate, there may be parties sitting on the sidelines.
“It depends on who they are and what their risk tolerance is,” said Seth Weissman, a partner at Jeffer Mangels Mitchell & Butler LLP. “Generally, they need to put money to work and are a bit more willing to finance some difficult properties.”
Ivanhoe said for borrowers unable to come up with additional equity or find an additional capital provider, there could be trouble for refinancing.
“Short of that, it’s hard to do. Not impossible. It’s hard to do a loan extension that gets through the trough,” Ivanhoe said.
And if a new investor comes in to take a subordinate position on the capital stack, that new investor also has to do its own underwriting.
“It’s a whole negotiation between borrower and lender. I’ve never seen one of these when a lender hasn’t asked for a paydown. Then it’s a negotiation of the amount. What the borrower is capable of doing,” Ivanhoe added.
And Weissman said one question is how motivated the owner is to actually keep the asset. If motivation is high, they may throw in additional equity.
“It’s asset-specific and market-specific. Office is clearly in a depressed market,” Weissman said. “Cap rates are going up at the same time that interest rates are going up. It’s hard to refinance.”
Repurposing Is Unlikely to Gain Much Traction
Another question on the minds of owners is how much space they will need down the road, and with office vacancies currently high due to many employees working from home, the idea of repurposing for another use has gotten a lot of buzz. Experts, however, caution that such projects are costly and pose myriad logistical challenges.
“People talk about repurposing as kind of a panacea. It’s a great idea, and it should be analyzed,” Raines said. “But not every building can repurposed.”
Indeed, with cities facing a shortage of housing, many have looked at the question of turning unused or underused office space into housing. One major challenge there, though, is bringing light into units on the interior of the building. Plumbing and HVAC changes are also challenges.
“To effectively turn a property from one use to a very different use is often good in theory and extremely difficult in practice,” Weissman said. “Extremely expensive in practice.”
Indeed, when thinking about floor plate changes, owners may instead look to change the floor plan but still keep the property as an office asset.
“You won’t see significant new office development in any major market. You may see a new version of the way in which people utilize the office going forward,” Weissman said. “CMBS or just general loan maturity is really what’s going to drive everything.”
–Editing by Philip Shea.