Key Point
- Rising vacancies and rising interest rates and financing costs will likely create opportunities for distressed buyers with dry powder to acquire properties and real estate bonds at discounted prices.
- Office-to-residential conversion presents an opportunity to unlock the value of underutilized office space and address the housing shortage.
- Refinancing debt on acceptable terms remains difficult and will continue to strain the commercial real estate market.
The commercial real estate (CRE) market is in a period of transformation as remote work has reduced occupancy rates while at the same time rapidly increasing financing costs. This shift has created opportunities for investors willing to take on stressed real estate and associated debt, as well as those willing to take on the challenge of converting office space to residential use.
In this environment, lenders are changing their approach, lending more cautiously and demanding more protection. Borrowers who anticipate potential problems with their property should be proactive.
Hybrid work revolution
The impact of the COVID-19 pandemic on CRE has been widely discussed. Rather than being a temporary adaptation, hybrid work has become a permanent feature of the post-pandemic corporate workplace, leading to a reassessment of office square footage and configuration needs, driving up vacancy rates, especially in urban areas.
Hybrid work also gives workers more flexibility in choosing where to live and work, shifting demand for office space away from traditional metropolitan areas and creating more affordable space and flexible It spread to surrounding areas that could offer rental terms. In some urban centers, such as New York City, demand and rents for new luxury office space remain high, while the market for older buildings lags.
These residual effects of the pandemic, combined with steady increases in interest rates, funding costs, and inflation, have led to a large amount of stressed and distressed CRE assets. Many CRE owners are experiencing reduced cash flow and expect to have difficulty meeting their debt and liquidity obligations. As a result, non-performing loans have flowed into the bond market and stakeholders are looking to sell some of their CRE holdings.
This environment gives strategic, well-capitalized buyers the opportunity to acquire CRE assets at a discount and recapitalize them, using discounted debt to reposition assets or negotiate favorable terms with borrowers. Provides the ability to purchase. Opportunistic acquisitions and innovative redevelopment are expected in such markets.
These residual effects of the pandemic, combined with steady increases in interest rates, funding costs, and inflation, have led to a large amount of stressed and distressed CRE assets.
Practice points: Time is of the essence in CRE stressed or distressed sales. Distressed acquisitions typically occur in a buyer’s market, and buyers often require the ability to act on an accelerated schedule. You may not have the time to conduct detailed due diligence. But for companies with the capital, strategic vision, and CRE expertise, 2024 will be an advantageous year to leverage those attributes and turn challenges into opportunities for big rewards.
Opportunity to reuse office space
The hybrid work revolution presents an opportunity to contribute to the revitalization of cities and combat the national housing shortage by converting underutilized office space into residential units. However, the conversion from office to residential comes with significant challenges, including:
- Comprehensive infrastructure adaptation (for example., additional piping).
- Legal barriers to conversion, such as restrictive zoning regulations and building codes.
Some US cities, including New York, are aggressively reforming housing regulations to make housing conversion economically viable. The New York Plan includes:
- Expansion of buildings that can be reconfigured as living spaces.
- Conversion to a wider range of housing types.
Conversion offers attractive opportunities, including the possibility of building affordable housing, but conversion is not a panacea. The extent to which transformation contributes to the overall affordable housing stock will depend on public and private efforts.
Given the importance of tax revenue generated by CRE in funding municipal services in cities like New York, why we believe public officials and CRE owners will work together to make necessary reforms and encourage redevelopment. there is. However, in the face of rising borrowing costs, it is unlikely that the conversion will be possible quickly enough to avoid significant losses in the value of office buildings.
Practice points: Developers considering conversion should consider strategies to deal with existing tenants, such as tenant acquisition or relocation. You also need to be aware of the funding challenges. Lenders are typically cautious about financing conversions due to complexity and risk. For example, some lenders require clauses that harm the lender if plans or specifications are reconfigured as a result of an enforcement action or government decision for violations of building, zoning, or multifamily housing laws. are doing.
Lenders may also expand the recourse event to include losses resulting from the relocation and/or acquisition of existing office tenants necessary to complete the conversion. Finally, developers should recognize that conversion is not suitable for all buildings and be prepared for alternatives.
Funding challenges
With all the pressures facing the CRE market, financing is becoming increasingly expensive and burdensome. Additionally, the universe of CRE lenders continues to shrink as traditional lenders become increasingly selective with their capital allocation and small business banks exit their CRE lending.
In response to increased risk and interest rate uncertainty, lenders are adjusting their lending strategies to reflect a more conservative outlook. They are performing health checks on properties within their existing portfolio. New financing terms include higher interest rates and more stringent conditions, including tighter loan-to-value ratios, revised valuation criteria, tighter scrutiny of borrower and guarantor creditworthiness, and a focus on properties with high pre-lease activity. Often accompanied by strict underwriting standards. Tenants with high creditworthiness.
Going forward, the lender will guarantee to the sponsor the payment of all operating expenses in order to ensure the sponsor’s vested interest in the continued operation of the property and to extend the scope of traditional recourse obligations in certain circumstances. It is expected that more and more people will ask forfor example., to cover the lender’s losses if the property conversion cannot be accomplished by a certain date). These changes are creating challenges for developers and investors, who are finding it more difficult to finance their projects.
Borrower’s strategy
CRE borrowers need to adapt to the fact that we are in a lender market, particularly with respect to office and retail assets. Borrowers with debt due within the next 24 months need to be proactive and strategic.
When preparing for upcoming debt maturities, borrowers should consider:
- Early monitoring and evaluation. Aggressive planning (In other words., at least 12 months before the debt is due). A strategic plan should be assembled based on an understanding of the overall financial situation, as well as schedules, amounts owed, and penalties.
- communication. In stressful or difficult situations, you can benefit from establishing clear lines of communication with your lender early on. Debt restructuring can be a lengthy process. Taking pre-emptive steps can be beneficial, especially if the lender is unwilling or unable to own and operate the property. Borrowers with a good track record may be able to negotiate loan extensions or other modifications to provide temporary relief. Borrowers with larger loan portfolios and corporate- and asset-level debt may wish to explore comprehensive opportunities to right-size their overall capital structure.
- spare. Fundraising is still happening, but access to capital has become very important. If possible, borrowers should try to build up a financial cushion and emergency reserve. The availability of liquidity increases a company’s ability to weather recessionary pressures and maintain debt restructuring and distressed acquisition options.
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