With Commercial Real Estate Still Challenging, Lenders Offload Troubled Loans At A Loss

Authored by Mary Prenon via The Epoch Times (emphasis ours),

While leasing activity and vacancy trends suggest the U.S. commercial real estate market is stabilizing, office values are still well below post-pandemic peaks, recent reports show.

As owners scramble to make payments on under-occupied office buildings, many lenders are reluctant to foreclose to avoid the headache of taking ownership and reselling the properties, according to David Marino, cofounder of Hughes Marino, a San Diego-based corporate real estate advisory firm.

According to Cushman and Wakefield, a global commercial real estate services company, national office sublease inventory in the first quarter declined by 13.6 percent year over year, to 101 million square feet, while vacancy may have peaked. Sublease space peaked in January 2023, at 189 million square feet, according to the commercial real estate services firm CBRE Group.

A February report from the financial data and research company MSCI also shows that office prices are showing signs of stabilization, though they are still well below their post-COVID-19 pandemic peak. Commercial property prices rose by 0.3 percent year over year in January, but downtown office values declined by 1.3 percent, and were down by 40.2 percent from three years ago.

Massive Perks

Speaking recently with Siyamak Khorrami, host of EpochTV’s “Market Insider,” Marino said the commercial real estate market is still challenging, as the pandemic has made remote work a new normal. “The horses are out of the barn and never coming back,” he said.

An April 1 report from job search platform FlexJobs shows that remote-job postings in the first quarter increased by 20 percent month over month, with 65 percent of positions targeting experienced workers. The platform predicts continued growth in the work model for the rest of the year.

An April 16 Bureau of Labor Statistics report shows that 22.6 percent of workers teleworked or worked from home, a measure commonly described as remote work, in March.

Marino said about 85 percent of companies in the United States have had their leases expire in the past six years and have been able to resize, leaving many office markets with 20 percent to 30 percent availability. As a result, commercial landlords have been offering potential tenants massive perks, including free rent packages.

“I just represented a client in an engineering firm for 14,000 square feet, which is basically space for about 7,065 people. And the landlord that just bought a building down the street was in escrow and wanted to win this deal,” Marino said. “They gave us an eight-year lease with a year free. In other words, my client moves in at the end of this year and doesn’t pay rent in all of 2027.”

In addition, Marino said the landlord paid for all of the tenant improvements to remodel the space, plus a cash moving allowance.

‘B’ Loans

However, banks and lenders can face an even bigger problem when loans cannot be repaid. Rather than pursuing immediate foreclosure proceedings, many lenders are resorting to creative solutions that allow landlords to retain ownership of these buildings, he said.

Marino noted that there have been “hundreds and hundreds of foreclosures” throughout the country, in particular during the past three years. Typically, he said, commercial loans include a “balloon” provision, which requires repayment or refinancing within seven to 10 years, or the property must be sold.

“What’s happened in the last three years is a lot of owners have hit that balloon mark and interest rates went from 3 to 6 percent, so if your occupancy goes from 90 to 60 percent, you’re immediately underwater,” he said. “Lenders in those situations have generally foreclosed on the properties and resold them at a big discount.”

In some cases, lenders don’t want to foreclose because they don’t want to become landlords. As an alternative, Marino said, they may split an existing loan into two pieces. In this scenario, a lender could, for example, take a $100 million loan and set $30 million of that aside as a “‘B’ loan,” treating it as a different loan.

“What I’ve seen in the last three years is the lending community getting very creative, trying to salvage what they can,” he said. “The lenders don’t want to foreclose on the real estate, nor do they want to put somebody into default unnecessarily.”

According to Marino, some metro areas are affected more than others. In San Diego, he said, 11 high-rise office buildings have already been foreclosed or are going through a forced-sale process when the loan hit the balloon payment stage.

A couple of those buildings are being converted to residential use, which Marino describes as a “micro trend” and not a significant impact on office inventory nationwide. He noted that close to a third of quality buildings in the city have already transitioned through financial negotiations with lenders.

Downtown Los Angeles and San Francisco have also experienced their share of office building foreclosures, Marino said.

“There’s still going to be more, and the developers that own these things, frankly, are handing the keys back,” he said. “There [are] some really ugly tax consequences.”

For example, he said, if a buyer purchased a building for $200 million with $150 million in debt and today the building is worth only $80 million, the owner would rather walk away.

“These are typically individual assets with their own individual Partnership Agreement, and they’re collapsing all over the country,” he said.

No Signs Of Systemic Fallout

To Khorrami’s question about how this will impact banks and lenders, Marino said it would depend on the percentage of the lenders’ assets allocated toward commercial real estate.

“The rollover of the debt is typically distributed over many, many years, so you don’t have all these loans really expiring at the same time within one financial institution,” he said. “My experience so far is that we’re not going to see a collapse of the banking sector because of commercial real estate.”

While the road could be bumpy, he said, it’s not going to be a trigger effect like it was during the early 1990s. Many of the older vacant office buildings are being sold at land value, minus the cost of demolition to start over and convert them into residential projects.

RentCafe, a rental housing research platform owned by Yardi, estimated in a March report that about 90,300 apartment units were in the office-to-residential conversion pipeline nationwide at the beginning of this year, marking another record year for such projects.

The warehousing market, meanwhile, appears to be booming, Marino said. He noted that the rise of online shopping has created an escalating demand for huge warehousing space.

“You look at an Amazon distribution building, and some of these things are a million square feet,” he said. “They’re some of the biggest buildings in the country.”

The issue is that construction, including land acquisition, permitting, and design, can often take up to three years, he said.

From 2020 to 2025, Marino noted, 1.2 billion square feet of warehouse buildings were being constructed across the country. In another five years, he predicts, the country could see an unprecedented amount of massive warehouse construction.