Turnaround

Billions on the Brink: The Deepening Crisis in Commercial Real Estate

June 11, 2024  |  By James Fleet  |  5 Minute Read


By Jim Fleet, Peter Davis, Dan Paulus, and Mark Cohen

Introduction

The commercial real estate (CRE) sector is currently navigating a crisis that poses risk to banks, family and institutional investors, and the broader economy. Defaults are approaching historic highs, properties are being deserted, and financial forecasts are in jeopardy. The Wall Street Journal reports that more than $38 billion in office buildings within the United States currently face foreclosure – the highest dollar amount since the 2008 financial crisis. These circumstances are unlikely to reverse in the near term given the ever-burdening cost of capital, declining revenue volumes, and reduction in net rental rates required to attract desired tenants. As the crisis grows, financial institutions and investors must seek effective strategies to preserve their investments.

This article examines in greater detail the trends affecting the CRE marketplace and what steps lenders and investors must take to protect their assets as well as why they need to seek advice from a seasoned team of industry experts.

Multiple Forces are Negatively Impacting the Market

Remote and hybrid work models have drastically reduced the demand for traditional office space, leading to record-high vacancies across major markets. CoStar Group reports the current US office vacancy rate has soared to a record 13.8% (and heading higher), up from 9.4% at the end of 2019 coupled with a negative net absorption of 53.7 million square feet in the past 12 months. This increase in vacancy has intensified the competition for quality tenants, creating a deceleration in effective rental rates.

Cash flow pressures are mounting as commercial loans come due in a high interest rate environment. Moody’s estimates that 73% of the $18 billion in office loans maturing in the next 12 months will be difficult to refinance due to high interest rates, rapidly increasing operating expenses, insufficient property income, and escalating vacancies. According to real estate services firm Cushman & Wakefield, nearly 60% of US office space needs substantial reinvestment and 20% is completely undesirable without major renovations. The Wall Street Journal has reported that major institutions, including Blackstone and Brookfield Asset Management, are already in the process of surrendering high-profile properties to their lenders.

Inflationary pressures are aggravating the issue. Costs related to construction and maintenance are rapidly increasing with no end in sight. A recent release from the Association of Builders & Contractors, citing data from the US Bureau of Labor Statistics, suggested that nonresidential construction costs have increased a staggering 42.8% since 2020. As a result, property owners are implementing cash preservation tactics and delaying projects – including necessary maintenance and contracted tenant improvements (“TIs”). These actions erode leaseholder relations and significantly reduce the future value of a property.

The convergence of rising vacancies, increasing interest rates, and inflation-driven operating expenses and construction costs is pushing commercial real estate to the brink of collapse. The

CRE crisis poses risks to the banking sector as well. According to a Florida Atlantic University analysis of new federal data for the first quarter of 2024, the CRE loan portfolios of 67 of the nation’s largest banks are at higher risk of failure because their exposure to commercial real estate is greater than 300% of their total equity.

Banks and Investors Must Take Action to Protect Their Interests

Economic pressures are forcing lenders to make a critical decision – what actions will they take to protect their interests. Regulated lenders will be under pressure from the FDIC to reclassify loans as non-compliant. Unregulated lenders will feel similar pressure from internal credit policies and their investors. These controls force urgency and place lenders in a position to proactively protect assets and monetize collateral.

While swift action is necessary, hasty decisions could lead to further devaluation. Rushed sales and foreclosures have historically led to negatively impacted property values in a submarket. A 2018 study by Real Capital Analytics found that distressed asset sales typically fetch prices 20% below market rates. Moreover, rapid reclassification of loans and aggressive credit policy enforcement strain relationships, leading to lost opportunities for collaborative restructuring that may better preserve the long-term value of a property.

Preservation of Value Requires Discipline

Preserving the value of a distressed property requires a disciplined approach rooted in fundamentals. This includes determination of a current market value, assessment of highest and best use, identification of realistically forecast operating expenses, and selection of appropriate fiduciary strategies to maximize cash flow.

It is important to note that a single property may have several different uses. Some applications may provide better returns than others, thus increasing a property’s valuation. When assessing a property in a downward trending market, its highest and best use must be more carefully considered. Converting office space into residential or a mixed-use development may greatly increase value, positively affecting loan-to-value debt ratios, and converting non-performing loans into compliance. Identifying and implementing the best possible use for a property is key to enhancing its worth.

Beyond valuation, management of construction expenses is essential for optimizing the value of real estate. This involves projecting realistic costs for routine maintenance, contracted TIs, and necessary renovations. Managers must pay special attention when overseeing construction projects, especially in an environment where material and labor prices fluctuate daily. Anticipating and controlling expenses allows property owners to safeguard their cash flow, investment value, and enhance overall profitability.

Proactive restructuring of financial agreements is key when stabilizing properties under financial stress. Restructuring of terms through modifications and extensions can provide valuable relief during challenging periods. This approach is particularly important for properties that are not meeting performance expectations as it allows owners to meet obligations without default and can provide the time necessary to achieve performance. In more severe cases, receivership or out-of-court settlements

provide a more structured approach to address financial issues while preparing for sale or revitalization. These strategic maneuvers are vital for preserving value but can also be overwhelming for those who do not have experience implementing these strategies.

Conclusion: Lenders and Investors Need a Team of Experts

As demonstrated, management of commercial real estate in a distressed market requires a team of seasoned experts each having specialized skills. Financial analysts, legal advisors, construction managers, and valuation specialists must work together to formulate a plan and implement comprehensive strategies. Collaboration with the client enables proper risk assessment and the potential for the strategic repositioning of assets with current and projected market demands. With a diverse team, lenders and investors are in a better position to protect asset values, optimize financial outcomes, and enhance the competitiveness of their properties.

Acknowledgments

We would like to thank our colleagues Jim Fleet, Peter S. Davis, Dan Paulus, and Mark Cohen for providing insight and expertise that greatly assisted this research.

Jim Fleet is a Senior Managing Director in J.S. Held’s Turnaround & Restructuring group and a leader in the Investor Services group, where he specializes in providing guidance in turnaround / restructuring, investment banking in both M&A and refinancing assignments, and has served in interim CEO, CRO, and CFO roles. He joined J.S. Held in October of 2023 as part of J.S. Held’s acquisition of Phoenix Management Services.

Jim can be reached at jim.fleet@jsheld.com or +1 401 742 7553.

Peter S. Davis, CPA, ABV, CFF, CIRA, CTP, CFE, is a Senior Managing Director in J.S. Held’s Corporate Finance business unit. He has served as receiver for regulators, lenders, and shareholders. He has operated and sold virtually all classes of real estate and has significant experience designing sales processes to maximize recoveries.

Peter can be reached at pdavis@jsheld.com or +1 602 295 6068.

Dan Paulus, MAI, is a Senior Vice President in J.S. Held’s Economic Damages & Valuation practice. He specializes in providing solutions to complex commercial real estate (CRE) issues, including supervision and the appraisal of both single and multiple-asset properties and large multi-state portfolios for lenders and investors. He assists legal counsel, their clients, and other experts interpreting pertinent CRE issues pre- and post-discovery regarding disputed valuations or potential damages.

Dan can be reached at dan.paulus@jsheld.com or +1 602 738 5860.

Mark Cohen, PE, PMP, is a Senior Managing Director and Global Construction Services Practice Lead at J.S. Held. He has more than 30 years of dispute resolution, project advisory, claims analysis, and risk management experience, spanning a wide range of domestic and international projects.

Mark can be reached at mcohen@jsheld.com or +1 917 270 1795.


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