Commercial Real Estate’s Debt Maturity Wall Is Unprecedented. Is It Disastrous?
William Russo, Andrew Manley, and Ian Mackie
Refinancing CRE loans may be a challenge, but borrowers have options
Between now and 2028, the commercial real estate (CRE) sector will see more than $2.8 trillion in debt come due as mortgage loans and extensions made prior to and during the COVID pandemic run their course. This is on top of the $541 billion in debt that matured last year—the highest amount ever in a single year.
The vast scale of that debt, current state of real estate capital markets, and certain asset-specific idiosyncrasies are prompting speculation around whether parts of the industry are headed for a disaster. The situation echoes the 2008 financial crisis—the last time a CRE debt maturity wall loomed—further stoking fears about how (or whether) borrowers will be able to refinance and potential downstream economic effects.
To understand the seriousness of the current debt wall, it’s important to reflect on how the situation took shape and differs from what came before. Several key factors—including interest rates, collateral availability, and consumer behaviors—will play a consequential role in shaping what comes next.
Most important, borrowers (and their lenders) facing this challenging refinancing environment are not without options. Here’s what they should know.
Why This Debt Maturity Wall Is Different
This is not the first debt maturity wall or wide-reaching challenge the industry has faced. Prominent examples include the 2008 financial crisis and the savings and loan crisis of the early 1990s, which was caused by the outsized leveraging of the 1980s commercial construction boom. However, this moment does have some important differences.
The trend in capital costs and availability is different.
Capital costs generally compressed starting in the early to mid-1990s. While the approach to resolving nonperforming loans differed during the previous two crises, falling interest rates and steady value recovery enhanced the functioning of real estate capital markets and enabled borrowers and lenders to transact. Because capital costs compressed and asset values recovered, borrowers were more capable of servicing and ultimately refinancing debt. As a result, loan extensions led to positive outcomes, which created a tailwind effect for transactions.
The rapid run-up of interest rates since 2022 has created the opposite situation. Although the Federal Reserve is expected to relax rates in 2024 or 2025, over the past two years the industry has faced the fastest and most substantial interest rate hikes since the 1980s. Even with rate relaxation, the prevailing rate environment likely will remain elevated—in many cases by a factor of more than two.
All things being equal, the obvious effects of this situation will be two-fold: It will diminish borrowers’ ability to meet debt-service requirements (i.e., coverage) and will apply downward pressure on available loan proceeds. This will likely be intensified by valuation pressures, which will impact different asset classes in different ways.
Real estate capital markets are not functioning efficiently.
A dearth of CRE sales since the COVID pandemic has rendered price discovery difficult. As borrowers and lenders struggle to find valuation data points, we can expect a more intensive focus on existing or in-place cash flow in the underwriting of real estate loans and valuation of assets. Additionally, this focus will likely contribute to reduced loan proceeds as lenders’ appetites for underwriting prospective cash flows will probably remain muted until market clarity improves.
History suggests that price discovery will again become possible as transaction volume normalizes. However, fundamental shifts in the functionality and usage of certain asset classes likely will have a more enduring impact. This is especially true of the hardest-hit asset types, like retail and office, where tenant demand has become extremely difficult to underwrite.
The CRE sector is grappling with post-pandemic cultural shifts.
This occurs namely in declining demand for office space and shifting retail formats. Technology is the clear catalyst behind these trends, as remote work and online shopping have become commonplace. Unfortunately, solutions are not nearly as obvious; this has intensified questions about the reliability of cash flows.
COVID did not cause these changes. Rather, COVID accelerated existing trends as the sudden closure of offices pushed companies to widely use technology tools to maintain productivity. The average office space per employee had been shrinking for years, well before 2020, suggesting that a full return to occupancy may be unlikely even as the pandemic recedes in the rearview mirror.
It’s worth noting, however, that asset classes within CRE are not all facing the same circumstances. Some have benefitted from the same technological changes that have negatively impacted office and retail sectors. In particular, industrial warehouse and distribution space saw advantages from online retailing and the resulting need for efficient distribution networks to promote rapid delivery of goods.
Geography and age also play a part. Older buildings can face greater valuation pressure as tenants migrate or “trade up” to superior-quality assets. The same can be said for geographic markets; superior and more desirable locations will benefit from tenant migration to quality, while less desirable locations will continue to diminish.
In addition, in the UK and EU, borrowers with older buildings may face even more valuation issues than those with newer CRE assets thanks to stronger environmental, social, and governance (ESG) building regulations, particularly around energy efficiency. These requirements—typically involving expensive refurbishments to older properties—are coming into effect as many borrowers are exploring refinancing options, heightening their risk profile and raising refinancing costs on top of these other challenges.
What This Could Mean for CRE
Do these unique circumstances spell disaster for CRE, borrowers, lenders, and the broader economy? Short answer: probably not on a universal basis, but that doesn’t mean there won’t be challenges ahead.
The past six months have offered some startling examples of value deterioration in office space assets. They include a Washington, DC, office that sold for less than one-third of its loan value, as well as the tallest office building in Fort Worth, whose lender bought it back at a foreclosure auction for under 10 percent of its earlier sale price. Similar examples are likely to follow as borrowers and lenders are unable to “amend and extend” loans any further.
Yet a flood of distressed asset sales has not happened. This suggests that for the few borrowers that default, many more successfully negotiate with lenders behind the scenes. If this persists over the next few years, as the post-pandemic readjustment and financial recovery stabilize, then the debt maturity wall may prove to be more of a rolling hill.
Of course, it’s too early to definitively say how the CRE debt situation will evolve. The magnitude and direction of interest rates rising or falling will have a significant impact on capital costs, available loan proceeds, and financing transactions in general. Changing habits of consumers, employers, and employees may have a more enduring effect.
Options When Facing CRE Debt Maturity
Borrowers and lenders facing maturing CRE loans typically have three options available:
Refinance or extension. Refinancing is by far the preferred option for both borrowers and lenders. Extension is a viable strategy if value and/or market recovery will permit a future repayment. Yet refinancing or extending at a higher interest rate can prove challenging, especially if it results in reduced proceeds.
Lenders may demand a “cash-in re-fi” where the borrower must inject additional capital to balance valuation shortfalls to refinance or extend a loan. This may be a difficult ask for borrowers who are pessimistic about the future value of their asset and fear wasting further capital—or for those who don’t have the money. Negotiating is also more difficult when multiple lenders are involved.
Sell the asset. Though a less-common option to date, this may be the most attractive choice for borrowers either unable or unwilling to front additional capital to refinance a loan. It may mean that the borrower will make nothing—or possibly lose capital. In severe cases, the lender may suffer a principal loss. In the absence of more viable alternatives, however, this may be the best option for both borrower and lender.
Buyers with capital to spend, however, could snap up deals. In fact, opportunistic funds in search of distressed debt or assets are becoming increasingly prevalent.
Foreclosure. This tends to be the option of last resort. Lenders have learned that taking ownership of and managing collateral is too much of a burden and requires expertise that does not typically exist in-house. This is particularly true for small and regional banks. Still, foreclosures may result if borrowers and lenders are too far apart on better options.
Whether it proves to be a wall or a speed bump, CRE’s maturing debt situation differs meaningfully from what has come before, with expanding capital costs, inefficient capital markets, and profound cultural change creating a unique moment for the sector. The challenges may be significant, but current signs are not pointing toward disaster—and borrowers have tools at their disposal to weather what comes next.
William (Will) Russo is a managing director in BRG’s Corporate Finance practice specializing in turnaround and restructuring and commercial real estate. He has over twenty years of experience in consulting and corporate leadership roles, where he has gained expertise in financial analysis, credit rating analysis, and cash-flow modeling, as well as related policy and procedure development.
Email: Wrusso@thinkbrg.com
Phone: 908.392.3166
Andrew Manley is managing director in BRG’s Corporate Finance practice based in Washington, DC. He has over thirty-five years of commercial real estate and financial advisory experience with an extensive background in investment management, capital markets, and restructuring matters. He is qualified as an expert and has provided expert testimony in a variety of real estate matters.
Email: andrew.manley@thinkbrg.com
Phone: 202.839.3924
Ian Mackie is a managing director in BRG’s Real Estate Valuation practice. He has over thirty years of experience of providing valuation services of commercial real estate investments for litigation, transaction, reporting and taxation purposes. His practice areas cover all aspects of commercial real estate and development valuation.
Email: +44 20 3514 7147
Phone: IMackie@thinkbrg.com