From our Thought Leader Contributor, EY.

By EY Americas

Toby Jorgensen of Ernst & Young LLP contributed to this article.

Previously published on EY.com | Higher interest rates and the impact on real estate | EY – US

Distress in the real estate market will impact multiple parties. A recent EY webcast affirms scenario planning is key to success.

In brief

  • With rising interest rates and a slowed transaction market, the commercial real estate sector faces increased risk of economic distress.
  • Refinancing property debt will be challenging in the near term, with office at the center of the distress conversation.
  • The owners and stakeholders of real estate must defensively plan for the potential legal, tax and financial changes to their investments in a shifting market.

The near-term outlook for commercial real estate (CRE) has become increasingly clouded due to rising interest rates and lingering fears of a recession. Banks today are facing a perfect storm as higher interest rates have resulted in tighter credit standards accompanied by regulators more closely monitoring the quality of CRE loans. A tighter lending market, along with declines in real estate investment trust (REIT) stocks, suggest yield expectations on CRE have repriced, and price declines and distress in certain asset classes are underway. If we are entering a distress cycle, it’s in the early days, as transaction volumes are down a near-record 70%, according to Green Street,¹ making price discovery more elusive. While today’s environment is more stable than the events that unfolded in the Great Recession of 2008, economic clouds are starting to gather on the horizon. So, how can real estate borrowers weather a potential storm? Preparing a defensive strategy and building resilience in a portfolio’s capital structure will be the keys to success.

During the recent webcast, “Distress in real estate: a roadmap for navigating uncertainty,” Mark Grinis, EY Americas Real Estate, Hospitality & Construction Sector Leader, led a panel that discussed the implications of the current real estate market on lenders, borrowers and investors. The panel consisted of CRE industry experts, including restructuring, banking, tax and law professionals.

According to an EY analysis, deal volume in the CRE market has declined in tandem with rising interest rates, with CRE trades down approximately 70% in first quarter 2023 relative to first quarter 2022 volumes. Capitalization rates across all asset classes are increasing, albeit at a slower pace relative to interest rates, according to EY research. As investors perceive greater risk in CRE, pricing has fallen, and it is expected to continue to fall for the year ahead.

Office at the center of the distress conversation

While distress to date has been concentrated in certain metro areas and asset classes, at the center of the webcast’s conversation was the risk unfolding in the office sector.

When studying office fundamentals, the picture is clear: As occupiers continue to adopt hybrid work policies, demand for office space is softening, resulting in higher vacancy rates and higher volumes of sublease space. The aggregate effect of this trend has placed downward pressure on effective rents and has extended the time to lease vacant space on the market. Within the post-pandemic office landscape, these trends are notably evident in older, Class B office properties.

Dan Brandt, a panelist on the webcast and an Ernst & Young LLP managing director in EY-Parthenon’s Restructuring & Turnaround practice, said, “In office, there is an element of a supply imbalance. There is office property today that will need to be converted to some alternate use [due to lack of demand in its current form].” It should be noted that, with the economy slowing, the “office occupancy pendulum” may shift away from employees’ preference to work from home to the employer, who may demand a physical return to working together. However, across the board, softening fundamentals suggest that even the highest quality tenants are adopting smaller real estate footprints in the current environment.

Discussed on the webcast, a reported trade of an office property in San Francisco may be a leading indicator of the current state of the “B” office market. According to EY research, the asking price for 350 California Street in downtown San Francisco approached $300 million when it was taken to market pre-COVID-19 pandemic. Since then, the anchor tenant vacated the building, leaving the approximately 300,000-square-foot office tower with high vacancy. It reportedly traded in second-quarter 2023 for just 20% of the initial asking price in 2020. Webcast panelists agree that while this is one incident, it reflects broader challenges in the office market: migration out of gateway cities, the struggle of Class B product to attract credit tenants and the heightened risk appetite of investors.

Communication and collaboration: critical success factors to working through distressed scenarios

Regardless of the underlying asset class, what happens when a single property suffers declining cash flow, and the ability to meet debt service is threatened? Consensus among webcast panelists was clear: Lenders, borrowers, their attorneys and advisors must all come to the table to review the existing loan documents and determine the best path forward. Due to decreasing asset values, some properties coming up for refinancing today may have trouble obtaining a new mortgage sufficient to replace the one that is maturing. On the webcast, Mark Grinis outlined what decision points a borrower must consider when evaluating their assets (see below).

Potential pathwayOverviewLongevity/Considerations
Borrower-lender negotiations2-3-year loan extension to buy time (with % paydown)Short-term; re-evaluate in a few years
ForeclosureCollateral (property) goes back to lenderLong-term; note or collateral will likely be sold before collateral seized
RecapitalizeAttempt to replace existing capital structureMedium-term; transaction market halted, no pricing discovery
ConversionRedevelop for alternate property useLong-term; Basis of asset must be low with favorable city incentives in place

In terms of the logistics of managing distressed situations, the common theme expressed throughout the webcast was the importance of communication between lenders and borrowers. Additionally, throughout the process of considering loan restructuring alternatives, it is essential to consider the tax implications of each scenario for borrowers and lenders. As Sarah Ralph, EY Americas REIT Tax Co-Leader, explained, tax plays a critical role in scenario planning strategies and must be considered at the onset of discussions between borrowers and lenders. Debt modification, asset repurpose, foreclosure, acquisition of a distressed loan and cancellation of debt income all have tax consequences for the borrower. Any significant restructuring could be viewed as a taxable transaction and trigger a tax liability requiring a cash payment, which could make a distressed situation even worse.

Webcast attendees believe more distress is on the horizon — creating potential buying opportunities

While the office market seems to carry the highest risk, other asset classes are not immune to a weakening economy.

Accordingly, banks are pulling back on lending and scrutinizing potential deals much more closely than they did in 2021. A leader in the banking industry and webcast panelist mentioned the banks are closely monitoring the current situation, particularly what is unfolding in the office sector and the Fed’s next moves around interest rates.

With short-term rates significantly higher than they were 12 months ago, some investors are seeking to capitalize on the opportunity to acquire assets at lower valuations. As Brett Johnson, EY US Real Estate Strategy and Transactions Leader, explained, “it’s only a matter of time before private equity or REITs are going to use opportunistic funds to buy distressed assets.” Brett added that in evaluating buying opportunities, the first step is underwriting the collateral cash flows. He states, “underwriting will need to be carefully considered as rents and demand are down and expenses are up.”

Planning is key

Whether you are the owner of an underperforming real estate asset, a lender evaluating distress exposure or an investor seeking investment opportunities, the main takeaway from the EY webcast is clear: Planning for multiple scenarios and building resilience in your investment’s capital structure is key to success, along with keeping the open lines of communication open.

Panelist Brandilyn Dumas, a shareholder with Greenberg Traurig, LLP, says that now is the time to have proactive conversations with your lender about your asset or portfolio, and revisiting your business plan with your advisors will ease conversations as loans come to maturity. A banking panelist affirmed that the lenders are equally interested in open communication; banks are eager to know that the borrower is committed to the asset and want to understand the business plan moving forward so they can collaborate on a productive outcome for both parties.

The bottom line? To navigate the uncertainty ahead, owners of impacted real estate assets must scenario plan for multiple outcomes. Legal, financial, valuation and tax consequences of potential actions must be carefully vetted, with upside and downside scenarios thoughtfully considered. And above all, keeping the lines of communication open is an essential factor for success. Lenders, borrowers and investors must work toward mutually beneficial outcomes to optimize the interests of all parties involved.

Source

¹ “Property Insights,” Green Street LLC, 15 June 2023.

² Survey of approx. 3,500 cross-sector webcast participants as of May 2023.