March 12, 2024 – Rising interest rates over the past two years have created many challenges for the commercial real estate financing market. Although the Federal Reserve has signaled that interest rate cuts are on the way, the current interest rate environment remains a roadblock to many transactions. Parties who can avoid a transaction in the current environment may choose to do so, but with loans approaching maturity, that is not an option.
With approximately $2.75 trillion in commercial mortgages maturing between 2023 and 2027 (Trepp.com new tab, opens in new tab, July 2023), lenders and borrowers face difficult decisions. Below, we discuss the options available to lenders and borrowers and the analysis needed to implement those choices.
Refinancing
Many borrowers explore opportunities to refinance their property with a new loan. However, the interest rate on the new mortgage may be higher than the existing interest rate without knowing whether the property can withstand it. Determining the financial viability of the property at current interest rates is an important step in this process. For a detailed discussion of the comparative interest rate environment, see also “Interest Rate Worries: A Snapshot of the Commercial Real Estate Lending Environment” (opens in new tab), Reuters Law News, August 3, 2023.
Other challenges may also exist, such as problems with commercial property valuations. The Commercial Property Price Index maintained by consulting firm Green Street estimates that commercial property prices fell 22% at the end of 2023 from their peak prices in March 2022, but not uniformly across property types. As a result, many borrowers will not be able to obtain mortgages in amounts sufficient to fully repay their existing loans.
As a result of these trends, some owners will not be able to pay off their existing loans through cash-positive or cash-neutral transactions. Instead, they will have to put additional equity into the property at closing. Many owners will be unwilling or unable to make such additional investments and will look for other options.
sell
Some property owners consider selling their property due to existing market challenges or existing investment strategies. This can be an attractive option for sellers who cannot pay off their existing loans by refinancing at a lower loan-to-value ratio, but can pay off their loans by selling at market value. However, market value is also affected by the interest rate environment, and valuations will be lower when the cost of acquired capital is higher. Ultimately, many properties may have difficulty finding a buyer at an acceptable price.
These issues are reflected in declining transaction volumes in the commercial real estate market, which are down by up to 50% based on 2023 sales data (such as reports from CoStar Group), with some property types (such as office) more affected than others (such as multifamily and industrial). These volume declines are likely to continue until we see tangible relief in the interest rate environment.
Contract extension option
Borrowers will continue to look for other options when refinancing the property is unattractive and selling the property is not practical. Many adjustable rate bridge loans have extension options built into them, so extending the existing loan may be one option. Borrowers and their advisors should closely review their existing loan documents and evaluate their contractual extension options. The existence of extension options does not guarantee the viability of those extension options, as extension rights require the satisfaction of substantive and procedural conditions.
One common condition for extending a floating-rate loan is for the borrower to extend the existing interest rate cap to the new maturity date, with a strike price set based on the interest rate at the time the loan was issued. For more information on interest rate cap requirements, see also “Sudden Rate Rise Complicates Existing Floating-Rate Loans,” opens in a new tab, Reuters Legal News, November 20, 2023. Such requirements can become costly as a result of rising interest rates. For example, a three-year interest rate cap with a 3% strike price on a $100 million loan would have cost less than $100,000 in 2019. Today, that interest rate cap would cost $3.5 million, according to Chatham Financial's interest rate cap calculator.
Another common requirement for exercising an extension option is that the loan meets financial indicators. This is usually tied to debt service ratios and/or debt yield calculations. Common practice requires that at the time of extension, these indicators meet those at the time of initial closing. The same factors that make it difficult to refinance real estate also lead to problems meeting these indicators. However, many loans offer the ability for borrowers to partially prepay the loan in amounts necessary to meet these criteria. An analysis of the loan documentation should reveal such rights.
For borrowers who are able to meet the necessary criteria, exercising existing extension options will be an attractive option, in the hope that interest rate markets will improve and more permanent alternatives will become viable.
Out-of-contract extension
If a loan extension is not included in the existing loan documents, a borrower can still ask the lender for an extension. If possible, discussions should begin well before the maturity date so the parties can work toward a solution. Lenders are aware of the challenges and are often willing to consider an extension, especially if they are reluctant to foreclose.
When considering a request for an extension, there are several factors that borrowers and their legal advisors should consider. First, many lenders want to see evidence that the borrower has genuinely explored refinancing or sale options. Hiring a broker to explore refinancing or sale options can go some way to convincing a lender that the borrower is trying in good faith to avoid defaulting.
Second, an analysis of any recourse clauses is essential to determine the borrower's leverage in such discussions. Assuming the borrower has not invoked a recourse exclusion clause, a fully secured loan with a well-funded guarantor may have a tougher path than a non-recourse loan. Before approaching a lender, it is a prudent move to fully analyze any recourse obligations and ensure that no recourse exclusion clauses have been invoked.
If a lender offers an extension, it may be subject to conditions. Common conditions include an extension fee, partial repayment, the deposit of an interest reserve, and/or the creation of a static collateral reserve. These options improve the lender's financial position if the loan ultimately defaults. Borrowers may be able to negotiate to receive the reserve in the form of a letter of credit rather than cash, reducing their initial cash outlay.
Another common requirement is additional recourse by the guarantor. A normally non-recourse loan can be considered to be partially recourse. Also, a partially recourse loan may have an increased recourse amount. Lenders often view this additional recourse as an incentive for the borrower to aggressively pursue all options available to repay the loan on the extended maturity date.
The last option for a fixed-rate loan is to increase the interest rate. The new interest rate may be lower than the current market rate, but it will be a compromise between the two. In either case, the above requirements may be combined to some extent.
Workout and foreclosure
In the most extreme cases, if none of the above options are satisfactory, the borrower and lender may face a restructuring process. Common restructuring scenarios include negotiating discounted repayments, restructuring the loan, or another arrangement that does not involve the lender taking ownership of the property.
With a non-recourse loan, the borrower can work with the lender to select subrogation and other amicable foreclosure options. Such options should not be considered lightly. The borrower and its lawyers need to be confident that the recourse carve-out has not been triggered before asking the lender to hand over the keys to the property. If the recourse carve-out is triggered, depending on the nature of the carve-out, the loan guarantor may be liable to the lender for certain losses or the full amount of the loan. Similarly, the lender should do the same evaluation before agreeing to take the property as satisfaction of the debt.
If no agreement can be reached, lenders may begin contentious foreclosure proceedings, and the industry expects to see an increase in such activity in the commercial real estate sector unless significant interest rate relief is provided.
Conclusion
The interest rate environment will continue to challenge existing property owners and their mortgage lenders for the foreseeable future. Navigating these challenges will require a complex interplay of business and legal considerations, along with ongoing evaluation as the situation evolves.
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