A New Way to Drive a CRE Investment Reset

Michael McCarthy

Commercial real estate investors get ready! 2021 is finally here, the COVID-19 vaccine has arrived and there is a light at the end of the very long tunnel that the world entered in March of last year. Many of the seeds of opportunity for cash-flush investors, however, will be sown in the disruptions caused by COVID-19 that will not quickly resolve. For almost a year, the pandemic has battered the country, taking a toll on economic markets and commercial real estate lenders and borrowers who are feeling a significant and present impact.

What lies ahead? Strategic investors are realizing that in the midst of the current economic upheaval there are burgeoning opportunities to acquire debt instruments. There are several reasons for this.

First, a growing number of commercial tenants are failing to pay rent, and property owners are watching the impact on their cash flows. In addition, certain asset classes, such as retail and hospitality, are seeing a significant decrease in property values while others, such as multifamily and industrial, are remaining stable or slightly down. As a result, lenders and servicers will be faced with challenges. Certain borrowers and loans may benefit from a modification or workout while other borrowers will be unable to satisfy the financial obligations under their current loans, and the prospect for restructuring such loans may not be practical or economically beneficial.

Second, some of the nation’s banks (both large and small) are overleveraged in real estate. In November 2020, The Washington Post reported that nearly 60 percent of one particular national bank’s portfolio was in commercial real estate and that the FDIC considers 356 of the nation’s banks to be “concentrated” in commercial real estate. Fueled in part by that reality, tightening credit standards at that time for many lenders across the board were making it more difficult for borrowers to refinance loans that are approaching maturity or approaching the end of agreed upon forbearance periods. It appears, however, that with the arrival of the COVID-19 vaccine and the new year, some optimism is returning to the lending market. Even so, owners of severely affected assets will likely find it difficult to refinance.

Finally, some predict that the work from home model will permanently take hold as we emerge from the pandemic. Right now, this is unclear. If there is a fundamental shift in how and where Americans live and work, the result could create longer-term changes in the commercial real estate landscape. More Americans may seek to work from home and may realize that in the post-pandemic world, they do not necessarily need to live in expensive urban centers or shop from anywhere other than the comfort of their living rooms.

At this time, the real estate industry is watching and waiting to see how severe the impact of these factors will be. In any event, we anticipate that a number of lenders will look to sell a potentially large number of the troubled loans they currently hold. With uncertainty about tenant occupancies, low or nonexistent demand at hospitality properties, severely impacted cash flow, capital calls on debt funds and lending REITS, and COVID-19-related disruptions in the CMBS market, borrowers may turn to their lenders and servicers for relief.

Lenders and servicers may not be willing (or able) to make any meaningful loan modifications or to offer replacement financing. As a result, some of the nation’s banks, servicers and other lenders may be looking to clear their books of nonperforming loans, generate liquidity and avoid the hassle and expense of loan workouts, receiverships, foreclosures and potential litigation. In all likelihood, a wave of commercial real estate loans will be available for purchase in the market.

Peter Ballance

From this downturn in the economy, investors should be on the lookout for distressed and discounted real estate loans available for sale. With funds readily available, many investors are eager to purchase distressed and defaulted loans at discounted prices, often with the ultimate goal of gaining control of the underlying borrower or property through foreclosure or deed in lieu of foreclosure. For such an investor, this can be a win-win proposition. If the real estate and the loan recover, the investor will benefit from debt service payments on a loan amount that is greater than the investor’s investment, and the potential to earn a significant premium when the loan is paid off. If the loan remains in default, the investor will be able to exercise its rights and remedies under the loan documents and ultimately become the owner of the property.

Unlike past recessions, however, gaining control of a failing office, retail or hotel property at a deep discount does not necessarily mean that the new owner need only wait for the dust of the economic downturn to settle before property values recover and profits roll in. This downturn is different from others in our past. While many Americans want to get “back to normal,” some expect that for a large segment of the population, “normal” will not mean a return to the office, to the urban core, or to the suburban mall.

If this expectation is realized, the usage of many properties throughout the country will need to adapt to the changes in how Americans live and function in the post-pandemic world. An innovative approach to real estate development paired with readily available capital will be required. There will exist an opportunity to seize on the need to rethink potentially thousands of distressed commercial real estate assets and drive their adaption to a “new normal.” For creative and bold investors ready to take part, there may be opportunities to redesign significant portions of our urban landscape and part of this will be driven by a necessary reset in the value of declining asset types that is effectuated by means of discounted loan sales, short sales and foreclosures. 

During the Great Recession and in prior downturn markets, determining the value of a distressed asset could be accomplished with relative ease based on data from prior recessions, assumptions regarding continuing tenancies and the availability (or lack) of equity in the market. One significant difference between the debt sales that closed during the Great Recession versus the current market will be the difficulty in determining the value of the underlying real estate assets.

Sophisticated loan buyers must undertake a thorough analysis of the current tenancies at a property and their impact on value, including rental payments and delinquencies, remaining lease terms, rent forbearances or modifications, tenant credit worthiness, tenant bankruptcy risks and most importantly, the market for the current use of the property versus potential new uses. Potential loan buyers should also be on the lookout for litigation commenced by borrowers to evict tenants or pursue lease guaranties. This is especially important for loan buyers who ultimately want to own and potentially redevelop the real estate and will therefore inherit those lawsuits and their inherent risks, costs and delays that could severely hamstring redevelopment plans and budgets. 

In addition to the typical due diligence considerations, loan buyers should also examine how the timing of exercising remedies can affect the desirability of a particular loan. For example, a loan buyer looking to own the underlying property may be particularly attracted to a loan where the loan seller has virtually completed a foreclosure because the loan buyer could close on the purchase of the loan and immediately thereafter complete the foreclosure so that it could step into ownership of the property.  In so doing, the loan buyer can sidestep certain bankruptcy risks and hopefully avoid any need to deal with the original borrower. 

Albert Singer

Alternatively, if a loan seller has not yet taken any action on a defaulted loan, the loan buyer will need to formulate a plan for what to do after acquiring the debt.  Considerations to keep in mind are whether a receiver is necessary, the timing and cost for completion of a foreclosure, and whether there are any borrower bankruptcy or other litigation risks. In addition, if the capital stack includes mezzanine or subordinate debt, a potential loan buyer may want to strategically consider the acquisition of a defaulted mezzanine loan as the foreclosure process under the UCC can often be completed in a much shorter time frame than a traditional mortgage foreclosure. In such instances, the loan buyer will need to carefully analyze any intercreditor arrangements between the lenders to fully understand and appreciate the rights of each lender.

As the COVID-19 vaccine enables the world to consider the post-pandemic future, a changed American life may begin to crystalize. Out of the economic distress that has fallen on commercial real estate throughout the country, there may exist an opportunity to reset our cities and towns for a “new normal” that will come into focus over the coming months and years. It is almost certain that the purchase and sale of distressed debt will again become a thriving industry, as it was in the Great Recession, but this time, the opportunities for the real estate industry and for a reset of our urban landscape appear to be even greater. Now may be the time for smart, innovative investors with readily available capital to leave their mark on the world.

Michael McCarthy is a partner in Stroock’s Real Estate Practice where he advises commercial lenders and borrowers in connection with mortgage and mezzanine financing secured by commercial real estate and in connection with real estate capital markets transactions, including repurchase facilities.

Peter David Ballance is a partner in Stroock’s Real Estate practice where he represents lenders, borrowers, developers and property owners in a wide range of commercial real estate transactions throughout the country.

Albert Singer is an associate in Stroock’s Real Estate practice and represents developers, lenders, borrowers, landlords and tenants in a broad range of commercial real estate transactions.