Looming debt maturity presents an opportunity for real estate investors

Nearly USD $1.5 trillion dollars in U.S. commercial real estate debt will mature by the end of 2025, according to Morgan Stanley analysts, as reported by Bloomberg¹, with markets such as the New York City, San Francisco, and Miami metro areas leading the pack on CMBS distress, and other high-profile metro areas such as Washington, Los Angeles, and Houston not far behind.² Why, you might ask, is this of interest to commercial real estate investors?

At its September 2023 meeting, the Federal Reserve Bank (the "Fed") indicated that, while it would keep its benchmark rate unchanged at a target of 5.25% - 5.5% for the time being, it is poised to make one final upward adjustment by the end of calendar year 2023. Additionally, the Fed signaled that it is poised to make two cuts to the benchmark rate in 2024, which is two fewer than the Fed had indicated would be made at its June 2023 meeting.³ Even if the Fed begins easing interest rates in 2024, the benchmark rate will still remain substantially higher than it was even just a few years ago, which would negatively affect the profitability of mortgaged commercial properties approaching the end of their current financing cycle, should their owners refinance. Accordingly, many property owners will find refinancing unpalatable. 

In this environment, we can expect property owners to react in one of several ways, including: (1) refinance at then-current rates (an unattractive proposition for the reasons set forth above), (2) restructure their debt and extend the applicable maturity date (no doubt in exchange for granting concessions to their lenders), (3) pay off the debt by selling the underlying real property, likely at a steep discount, or (4) if all else fails, walk away from their properties and default on their loans, in which event the lenders (or a receiver, if a property goes into a receivership) may look to find a buyer - again, at a discount.

Additionally, many lenders, particularly smaller regional banks, have heavy exposure to real estate loans. Accordingly, they will likely be keen to unload some of these loans and will also likely be reluctant to refinance existing loans in order to reduce such exposure in their portfolios, rendering the third and fourth options all the more likely. In fact, there have already been a handful of high-profile defaults in the U.S. office and retail markets in cities such as Los Angeles and San Francisco.

This state of affairs presents a potential opportunity for real estate investors (particularly those who are not financing-dependent) to snap up prime market real estate at a discount. In particular, Morgan Stanley estimates up to a 40% drop in office and retail property valuations.⁴ While some investors may balk at acquiring office properties given the recent work-from-home revolution driven by the COVID-19 pandemic, with many employers now mandating that employees appear in the office three or more days per week, it does not appear to be all doom and gloom for the office sector – while Class C assets will likely struggle, Class A and some Class B assets may, in fact, present an attractive investment proposition in targeted markets. Increased office presence has historically also had a positive effect on surrounding retail properties. Regardless of property type, savvy and patient investors could identify and acquire high-quality real estate assets at a discount, and then extract fresh financing (or refinance, to the extent financing is used in the initial acquisition) once interest rates decrease.

As the real estate landscape continues to evolve, those who seize this opportunity stand to reap the rewards of a potentially resilient and profitable investment. Please contact your Withers attorney or the author for guidance or with questions on this timely topic.