The Great Recession of 2008 seems like a distant memory to many of us. The Dow Jones is flirting at 20,000 up from a low of 6,300 and the real estate market, which many blame for the demise of the global economy back then, has been humming along for five years. What could possibly go wrong? Apparently, a lot.
Commercial mortgage backed securities (“CMBS”) were all the rage back in the early 2000s and represented a significant portion of all commercial real estate loans in the United States. Because it was incredibly easy for lenders to get the loans they originated off their books by securitizing them, money was flowing freely back in 2006 through 2008 and underwriting standards became somewhat lax. Guess what? All those 10 year loans that were originated during the boom years of 2006-2008 are starting to come due and the lending environment isn’t going to be as generous when it comes time to refinance. Stricter loan underwriting requirements post-2008, new CMBS risk retention regulations under Dodd Frank which come into effect later this month, and the specter of rising interest rates announced by the Fed earlier this week all may make life very interesting to property owners.
A Wall Street Journal (WSJ) article, Trouble Brewing in Commercial Real Estate, published on November 15, 2016, reveals that we are starting to see the first signs of trouble on the horizon. According to the article, commercial property sales volume was down 8.6% in the first nine months of 2016 as compared to 2015. Another alarming statistic is the significant increase in the rate of delinquencies on commercial mortgage loans. Close to 5.6% of the almost $400 billion of commercial mortgage loans packaged into securities were more than 60 days late in payment as of September 2016 as compared to 4.6% earlier in the year. That’s close to $25 billion of debt that could be on the brink of foreclosure.
Again, per the WSJ article, Morning Star Credit Ratings LLC predicts that “borrowers won’t be able to pay off roughly 40% of the commercial mortgage-backed securities loans coming due next year.” Much of the increase in property values over the past 10 years has been driven not by rent growth, but by record low interest rates which have enabled owners to pay more for assets. Think of a $1,000 government bond that pays $40 in annual interest when issued (4%). When interest rates fall to 3%, that same bond may sell for $1,333. It’s the same thing with real estate. A Class A office building that throws off $500,000 in net operating income may be worth $6,250,000 when cap rates are 8%; however, if cap rates for that type of asset drop to 7% due to declining treasury rates, that same asset may be worth $7,142,857.
Just as property values steadily rose as market interest rates fell over the past eight years, they are likely to fall should interest rates rise in the months ahead as has been signaled by the Fed. Simply put, many buildings have changed hands over the past five years at prices that, all else being equal, wouldn’t make sense if interest rates were 200 basis points higher. Absent improvements in the asset fundamentals such as increased occupancy and/or rental rates, the assets won’t be worth as much in a higher interest rate environment as they were before and will not be able to service the debt on higher interest rate loans. Making matters worse, the net available loan proceeds from CMBS transactions won’t be as plentiful going forward if Dodd-Frank is not repealed. Issuers of CMBS will now be required to retain 5% of the securities they create. With less available loan proceeds and declining market values for properties, many property owners may find that they have trouble raising the loan proceeds necessary to refinance their existing loans. Stricter loan reserve requirements and tighter loan to value ratios will further burden owners looking to refinance their properties.
What does this mean for tenants? Their lease could become a very valuable piece in their landlord’s attempt to reposition the asset. The difference between a vacancy and a long-term lease could translate into significant differences in the building’s valuation by lenders and potential buyers. That means the tenant could have significant leverage when it comes time to renew its lease or cut a deal for a new lease. A pending loan maturity for the landlord may also provide an opportunity for a tenant to restructure its lease in advance of the natural expiration on favorable terms.
The problem of course is that some landlords may not have the ability or incentive to strike very aggressive rental deals. While the landlord may recognize that a material vacancy could cause it to lose the building to its lender, striking too aggressive a deal with a tenant on a new or extended lease may reduce the building’s value to less than the underlying debt resulting in the same outcome. Any deal that doesn’t maintain an asset value in excess of the underlying debt isn’t worth doing if the loan is non-recourse. This is especially true if, as is typically the case, the lease deal requires the landlord to come up with additional capital for tenant improvement allowances, building improvements and transaction costs.
Tenants not only need to understand how their landlord’s loan situation will affect their bargaining leverage when it comes time to negotiate a new lease or renewal, they need to make sure that the landlord can carry out the financial obligations it commits to in its lease. We all know that a key issue in most lease negotiations in lease security for the tenant’s obligations including letters of credit or cash security deposits. However, with mortgage loan defaults steadily rising and storm clouds forming in the distance, it may be time for tenants to start focusing more on the landlord’s credit; especially when the landlord is a single purpose entity whose only asset is the building. Should the loan go into default or the landlord lose its equity in the building, the tenant may find that, absent a good non-disturbance agreement with the lender, it is out of luck.
Everything has been going gangbusters for the real estate market the past five or six years. Unfortunately, a sleeping giant is starting to awake from a ten-year nap and it may cause major problems for landlords across the country. Real estate goes in cycles and we have been riding a long upturn. If and when things turn, and there are indications that it will, tenants need to be prepared to both take advantage of the opportunity and protect themselves from the risks.