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Wanted: Capitulation – Resetting Property Values and the Path to Liquidity

Oct 16, 2023

Since the beginning of the year, we’ve been seeking clarity on the direction of the commercial and multifamily investment markets. Clarity on interest rates, on inflation, on the sustainability of the job market and consumer spending, and on property values -- all of which are necessary for capital providers to get back to business. 

After a wave of optimism last winter (real estate, after all, is by nature and necessity an optimistic industry), by the spring we wrote that the fog had only thickened. As we embark on the fourth quarter of 2023, the fog is beginning to clear, revealing a landscape of falling values, illiquidity, and increasing distress as the 10-year Treasury rate approaches 5%. “Higher for longer” has become something of a cliché, and “longer” may turn out to be longer than you think. We are in the new normal.

Real estate remains cyclical, and downturns are not fun. When values fall, newly overleveraged owners lose their equity and, potentially, the ability to hold their assets into the next inevitable upswing. The mood of the industry has changed since mid-year. There is no more pretending. 

Since Labor Day, distress – for owner/operators, for investors, and for their lenders – is the focus of every meeting, conference, and media report. Of course, one investor’s distress is the next investor’s opportunity. 

Real estate downturns result in transitions from one owner to the next, replacing the high basis of the previous cycle with a lower basis in the current one, that low basis enabling the new owner to achieve appropriate risk-adjusted returns. In other words, the path to liquidity in a downturn is through ownership transfers to new investors who can make money on those properties where the old owners no longer could. 

That transfer of ownership and resetting of basis requires capitulation. Not just the challenging recognition by owners that their asset has lost value but the decision to realize that loss through a sale. Owners who purchased properties in the last decade bought at capitalization rates lower than today’s risk-free short-term and long-term Treasury rates. 

Not only is real estate not risk-free, but the perceived risk premium for the sector has continued to grow through the first three quarters of the year, widening credit and bid-ask spreads. The sudden perception of a riskier investment environment is typically the trigger for a downturn, even when the added risk – in this case primarily a higher cost of capital – was artificially created by regulators.

The Best Kept Secret – Property Values

Despite all the rhetoric in the press and industry reports, there aren’t enough transactions to know what has happened to property values. And it’s important to note that their decline, and all the distress in the system, shouldn’t be painted with too broad a brush. 

Downturns force investors to distinguish among properties, and each has its own story of location, usage, tenancy, debt, and sponsorship. Some office buildings are doing remarkably well, while some industrial properties have rising vacancies. Several firms publish indices that illustrate changes in property value. 

For example, the Green Street Commercial Property Price Index at the end of the third quarter estimated that values across property types had fallen 16.4% since their peak in March 2022, with an expectation of a further 10% value reduction to trough. By major sector, office fell 31%, multifamily 22%, malls 16%, industrial 7%, and lodging 5%. All the indices indicate a fall in value in varying degrees. 

Given the lack of transactions, we cannot estimate the accuracy of these statistics, but they are directionally highly informative. Broad averages hide the triumphs and the misery, but the numbers demonstrate that distress is property type- and location-agnostic. 

The inability to develop a reliable range of asset values, and the recognition that we haven’t hit bottom, have zippered shut the pockets of equity and debt capital providers. Nonetheless, enormous capital is required to successfully bring the industry through this cycle. Almost all real estate investments are leveraged, and those loans are coming due. It is that combination of falling property values and maturing loans collateralized by those properties that is creating a tsunami of distress that could engulf the industry without abundant fresh capital. 

The volume of upcoming maturities seems to be magically growing each month, with Trepp’s latest estimate of $2.8 trillion in loans expected to mature between 2023 and 2027. We face a situation with a huge demand for capital with little capital available to meet that demand. The most basic economics lesson will conclude that, irrespective of any actions of the Fed, the cost of capital will climb even further.

What’s a Lender to Do?

Lenders of all stripes – banks, insurance companies, mortgage REITs, debt funds, and the commercial mortgage-backed securities (CMBS) market – haven’t had the time to make new loans even if they wanted to. They are too busy recomputing coverage and debt yield ratios, monitoring covenant compliance, arranging extensions and loan modifications, and holding their breaths for the next wave of maturities and interest rate hedge expirations. 

Each loan with an upcoming maturity needs a strategy, which is driven by local market trends, collateral performance, the perceived changed in valuation, and the liquidity and willingness of the borrower to achieve its business plan and further invest in the asset. Lenders have become stricter about the timely receipt of property financials and rent rolls, and the reliability of that data is becoming a hot topic for lenders with major decisions to make.

Before looking at resolution trends, it must be noted that, apart from the office sector, properties are generally performing well. Although rent growth has slowed and operating expenses have inflated, properties held for more than a few years have had respectable growth in cash flow. Still, lower loan-to-value ratio requirements means the borrower will almost always have to contribute capital to refinance a deal – and that’s a critical decision in the capitulation process. 

Longer-term holds should be able to squeak through with minimal new capital. But the capital gap widens in the ubiquitous short-term value-add deals where the sponsor was unable to achieve the projected increase in rent, and in conversions from construction to permanent financing when the property is still in lease-up and there isn’t cash flow to support the financing.


The easiest thing for lenders is to delay the inevitable by extending the loan. This approach gives everyone time to determine the direction of both property performance and interest rates, and enables the borrower to continue paying a lower interest rate, often with a small loan reduction for good faith. The hope is that by the time the extension matures, rates will be lower. But with the Fed’s dot plot now extending the reduction of the Fed Funds rate, extensions must get longer and longer for that hope to be realized. 

According to Trepp, there have been about $5.6 billion of CMBS loan extensions in 2023, likely a small fraction of the volume in the broader market. Sure enough, their study indicated that as “higher for longer” became more certain extensions have gotten longer, stretching to three years. Extensions are a gamble on rate trends, and if rates remain at their historical norms the problems will still be there when the extensions expire.


If the property is not generating sufficient cash flow to make a simple extension feasible, a more complex modification may be necessary. These deals can take many forms, but most prevalent today is a partial paydown of the loan and a cash sweep. Cash sweeps obviously protect the bank in the short run, but they make it impossible for borrowers to accumulate cash in preparation for a capital infusion at maturity, potentially resulting in further distress in the future. Some lenders are keeping below-market rates and requiring principal paydowns if the property achieves performance milestones such as securing new tenants.

Loan Sales

In situations where the property performance is weak and the borrower has shown no interest in supporting it, lenders must decide among discounted payoffs, foreclosures, and loan sales. The first two are typically an anathema for lenders. 

Banks don’t want to reset the value of their entire portfolios by cutting a deal with one or more borrowers, and discounted payoffs are usually not allowed in securitized deals. Foreclosure is the worst nightmare for most lenders, who then must manage and sell the property. Accordingly, many banks have turned to loan sales to just get rid the problem, and they are taking quarterly reserves to enable this strategy. 

The volume of sales is increasing, and the sale of the Signature Bank portfolio will be the largest deal since the Global Financial Crisis. Industry sources say loans are selling at 10%-to-20% discounts to par. These sales are a ripe opportunity for private equity and other opportunistic investors to make outsized returns if they have the workout and asset management infrastructure to quickly resolve each credit.

Friendly and Unfriendly Foreclosures

As noted, most lenders, particularly banks, do not want to own the collateral. It is not their business and owned real estate has high capital charges. Yet in this downturn, unlike the others over the last forty years, borrowers have been more and more willing to turn over the keys. This may reflect the rise in property ownership by private equity and sponsored syndications of passive investors, which typically have short-term investment horizons, lack additional capital to invest in projects, and are incentivized by promotes. 

Cancellation of debt tax is often a deterrent for owners to give up the keys, but private equity funds can pass that liability through to the investors. The good news is that many borrowers pursuing friendly foreclosures aren’t just walking away but helping the lender reposition and sell the asset. Reputation still means something. For quality assets, longer-term holders such as REITs, family real estate businesses and family offices are swooping in to build their portfolios at a discount. 

The Impact of Climate Change: We’re Having a Heat Wave – and Storms, and Fires…

We have learned even in the past quarter how rapidly climate change can destroy property with huge economic losses to owners and their lenders. Insurance rates across markets and landscapes have skyrocketed during the past year, further weakening collateral cash flow. 

The number of locations that are not impacted by potential floods, fires, or the sixteen other categories of natural hazards tracked in FEMA’s National Risk Index is shrinking rapidly. Buyers and their lenders by necessity must now weave a full hazard analysis into their underwriting to assess the potential physical and operational damage climate may cause over the duration of the investment. FEMA and other data sources are mapping risk by zip code to support this analysis, and when reviewing these maps, it becomes immediately obvious that the most populated areas in the country are the most vulnerable. 

How that will change the mindset of families and business in their choice of locations will become a more important topic of analysis in the coming years.

Adding Up the Distress

The long-term impact of rising rates, thinner operating margins, continued overbuilding in some markets, and all those maturities add up to significant distress for the foreseeable future. Each month CMBS special servicing and delinquency rates grow, propelled by the office sector where delinquencies rose from 1.6% to 5.6% in the last twelve months, and which now comprises over 50% of all loans in special servicing, per Trepp. 

Trepp also reports that among the banks, which hold half of all commercial and multifamily mortgages on their balance sheets, charge-offs are rising exponentially, from $49 million in the fourth quarter of 2022 to $149 million in the first quarter of 2023 to $459 million in the second quarter of 2023. 

A recent study by Newmark found that a whopping $436 billion of multifamily debt is potentially troubled. That’s almost 20% of all loans secured by what recently was most investor’s favorite asset class. If one fifth of all loans have issues, resolving almost a trillion dollars of debt will take a lot of work, and lot of time, and a lot of capital. 

Looking Forward: Fourth Quarter 2023 and Beyond

While we have a tough road ahead, we still have some tailwinds. The labor market remains remarkably resilient, outperforming expectations in September. After a surprising surge in job openings in August, the ratio of openings to unemployed people is now 1.5x, according to the Bureau of Labor Statistics. 

American consumers continue to spend and are showing a preference for in-store shopping. There is still over one trillion dollars of excess savings in the system and a decline in gas prices could spur new consumption in time for the holiday season. As noted, most property types are continuing to perform. The reduced probability of a recession is sustaining demand for space and reasonable rent growth in historic terms. 

On the other side of the coin are several potential black swans, including further bank failures and the impact of higher capital requirements promulgated in the Basel III Endgame, rising oil prices, escalation of the conflicts in Ukraine and Israel, a shutdown of the U.S. government, a contagious China credit issue, recurrence of COVID-19, and the 2024 presidential election. What’s closer to home are the large volumes of maturities in a high interest rate environment that will likely last longer than our optimistic industry ever imagined. 

As noted, there are many buyers for properties, even with high mortgage rates, as long they can buy at the right basis, that is, pricing that generates sufficient yield. And that requires sellers to capitulate to lower property values. These decisions are hard and typically made under duress, which could be a maturing mortgage or the need for significant additional capital to attract office tenants. The process will be slow and painful. 

Every property has its unique attributes and potential and every deal will be bespoke, requiring extensive diligence and analysis. Investors will want to build relationships with their lenders to have reliable sources of debt capital and someone to talk to about bumps in the road. Banks are typically relationship oriented, but they are likely to notch down their real estate exposure in the face of regulatory and internal risk management scrutiny, as well as the possibility of higher capital charges and therefore less profitable lending to the sector. 

The CMBS market is not relationship- but transactionally-oriented, and the complexity of working with special services causes CMBS volume to decline after every downturn. Fannie Mae and Freddie Mac are continuing to lend to the multifamily sector but increasingly focused on affordable rather than conventional properties.

The remaining source of capital is private debt. The many large and small “shadow lenders” who operate outside of regulatory scrutiny and have raised enormous sums for just this situation. These lenders are ready and willing to supply capital to the industry, but the loans are expensive compared with other lender groups. The share of lending done by these funds will likely rise significantly over the next few years, but there will be no way to measure their progress. And because they charge more, it is possible that commercial and multifamily mortgage rates will remain high even if at some point the 10-year Treasury rate begins to fall, making permanent the higher cost of capital and reduced yields for real estate investors. 

Given these new parameters real estate is likely to become more of a long-term investment, as it was in yesteryear. Private equity will be the intermediary, buying at a discount and flipping to the next round of owners. And those owners are likely to be family businesses, family offices, institutional asset managers, sovereign funds, and REITs, all of whom have the capital and patience to use less leverage and ride out temporary dips in value. 

The shorter-term players have already made the transition from property investors to private lenders. It will likely take some time before we see a robust comeback of promote-driven value add syndicates, although that type of capital is always needed to improve properties. 

Investors will adjust to higher interest rates, and the economic recovery will fuel demand for space over time, even office space. Opportunities endure, and each of these iterative steps will serve to restore liquidity to the property sector.

Through this period of industry challenges and our countless discussions of the impact of higher rates and inflation on yields and values, it is important to remember the non-investment side of real estate. Commercial and multifamily properties are the backbone of our communities, and owners and developers must continue to invest to provide the highest quality space for our tenants to live and conduct their business. That cannot happen until market liquidity is restored.



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