It’s one of the toughest questions plaguing commercial real estate today: What is to be done with a pileup of maturing — or past-due — loans worth hundreds of billions of dollars when refinancing is all but impossible?
For most of this year, and seemingly since the pandemic began, the most common solution has been to extend loans until financial conditions improve. But any relief on interest rates remains off in the distance, and the most prolific class of commercial real estate lender, regional banks, is under pressure to get CRE off its books.
Barring a shocking economic reversal, some regional banks will be forced to make a deal or foreclose on delinquent loans, which continue to rise in number. One form of deal that could rise to prevalence is the discounted payoff, or DPO, debt negotiators told Bisnow.
“The discussions about [DPOs] are increasing,” said Amy Hatch, vice chair of law firm Polsinelli’s financial services litigation practice. “I can’t say I’ve seen a bunch closing or a bunch happening, but I think it’s on people’s radar as a tool, probably more than a year ago when we were talking about extending to see what happens or finding options for borrowers.”
A discounted payoff is when a lender agrees to be repaid at a lower price than the outstanding balance on a loan. A borrower typically offers a DPO if it has financing lined up, either in the form of a buyer who agrees to pay the DPO price for the building or by obtaining a new loan to retain possession.
When a lender accepts a DPO, it realizes the loss of a loan’s value on its books. For banks, there is no functional difference between a DPO and selling the loan for the discounted price, Newmark Loan Sale Advisory Group Executive Managing Director Brock Cannon said.
But Silicon Valley Bank’s collapse in March came after it sold $1.8B worth of assets at a loss and announced the need to raise more capital, prompting a run on deposits that spiraled out of control. And even though many surviving regional banks want to decrease their exposure to commercial property loans, they have been unwilling to take the losses that doing so would require, whether through outright loan sales or DPOs, Cannon said.
“If you were hearing about DPOs, then it would mean a lot of lenders are taking a lot of losses right now, and it’s just not happening,” he said. “They don’t have the pressure on them to sell loans at a big discount.”
The Federal Reserve is poised to raise interest rates again in the next few months and keep them higher for longer than the market expected even six months ago, based on comments Fed Chair Jerome Powell made at the Federal Open Market Committee’s September meeting.
Interest rate hikes put downward pressure on property values, but the uncertainty of where they will end up and how long they will stay there has paralyzed the acquisition market since the second half of last year.
Green Street’s Commercial Property Price Index was down 16% in August from its March 2022 peak, but a lack of sales and appraisal-triggering refinancing deals makes high-level data less useful than it is in most years, Newmark found in its second-quarter U.S. capital markets report.
The collapse in transaction volume this year is making it difficult for anyone to agree on how much properties are worth as maturity dates approach and, in many cases, pass by, MSCI Chief Economist for Real Assets Jim Costello said. Borrowers and lenders are finding themselves at odds in negotiations over extensions and/or workouts.
“I put a low probability on the notion we go back to 2021 and early 2022,” Costello said. “The only other way this could change is if current owners give up the ghost and come to the realization that holding out for market-high prices might not be viable given how much things have changed.”
Second-quarter U.S. debt research reports from Newmark and credit analytics firms Trepp and MSCI all found that much more debt is still on track to mature this year and next than further in the future. The numbers of new loans and willing lenders have plummeted. And delinquency rates continued to rise for CMBS loans across most property types.
“It feels like we’ve been talking about this for a long time, but we’re still early,” CohnReznick Debt Restructuring and Dispute Resolution Managing Director Debra Morgan said. “There’s probably another rate hike or two coming, so the market hasn’t settled into loss, it hasn’t settled into recovery, it hasn’t settled into anything yet.”
Still Extending, Still Pretending
Plenty of borrowers are seeking creative solutions like DPOs and injections of rescue capital like bridge loans or preferred equity as they search for any way to avoid lump-sum payments and the consequences of being unable to come up with the cash, Hatch said. A similar sentiment has been echoed at multiple Bisnow events in the past month, including the 2023 National Finance Summit in New York.
In an environment of falling values and scarce, expensive new debt, discounted payoffs can be beneficial to both borrowers and lenders if extension negotiations and refinancing searches are going nowhere, Related Cos. Fund Management Senior Vice President Sam Friedland said at the National Finance Summit.
Hatch advised on a DPO deal that closed on Thursday, she told Bisnow.
Owners of maturing loans are doing whatever they can to get borrowers to put up enough cash to justify an extension or otherwise keep loans on their books as performing assets, all while facing intense scrutiny over the health of their balance sheets.
“There’s just a bad gap between what borrowers are willing to pay and what lenders are expecting,” Cannon said. “Borrowers aren’t motivated to sell their property to pay down loans right now. And that’s a big mistake lenders are making, letting borrowers drive the bus.”
In Q2, banks “charged off” $459M of office-backed debt, meaning they accepted that much in future losses for loans on their balance sheets, according to Trepp data. That was more than triple what banks charged off in Q1, which at $149M was also over triple the $49M banks charged off in Q4 2022.
Net charge-offs also rose sharply for hotels in Q2, while multifamily net charge-offs rose modestly, Trepp found. Even though short-term loans backed by apartment buildings should be especially damaged by the changes to the economy in the past year and a half, government-sponsored entities Fannie Mae and Freddie Mac are performing their function of keeping liquidity alive in multifamily, the Mortgage Bankers Association found in its Q2 omnibus report released Friday.
Lenders are still more apt to write down, or charge off, the value of a loan as it sits on their books than accept a DPO, Cannon said.
“I don’t understand the marks they’re writing down to. No one really does,” Cannon said of banks. “But it helps them change the performance of the loan on the books. If you do DPO with a borrower, you’ve got to report that as a loss. It’s like if you do a loan sale at 50% of par, you have to tell your investors that, especially if you’re a public bank.”
Something’s Gotta Give
What helped restart debt markets in the wake of the Global Financial Crisis was the Federal Deposit Insurance Corp. selling the loan books and foreclosed properties of hundreds of banks that had failed, Cannon said. Only three banks failed this spring, but the resulting crisis of confidence accelerated banks’ retreat from commercial lending, according to Newmark’s Q2 report.
The FDIC is marketing Signature Bank’s $33B commercial loan portfolio for sale in what could be a watershed moment for pricing comparisons. For now, lenders are using extension negotiations to clean up their paper, like getting borrowers to waive liability clauses, CohnReznick’s Morgan said.
“Forbearances until the first quarter of next year I’m seeing a lot,” she said. “We’re either going to see a bunch more forbearance agreements in the Q1, or we’ll see paper being sold.”
One public company has made a DPO deal in the past two months: Retail REIT Urban Edge Properties paid $72.5M on what had been a $117M CMBS loan for a mall in Puerto Rico by exercising an option added in a 2020 modification, it announced Aug. 30. Urban Edge obtained a new $82M loan from Banco Popular de Puerto Rico to pay for the DPO. The company declined to comment through a spokesperson.
Lenders will be more likely to accept DPOs on office buildings if and when they accept the reality that those properties have lost a large chunk of value, Cannon said. For all sectors, acknowledging that the environment is unlikely to improve until 2025 at the earliest is only a matter of time for many lenders, Hatch said.
“It makes more sense right now for a lender to say the borrower put it out to the market, this is the highest value they can get, and this borrower is otherwise going to default,” she said.
Avoiding the expensive and drawn-out foreclosure process would be among the most likely reasons for a lender to agree to a DPO, Hatch and Morgan said. Rising delinquencies indicate that more and more borrowers are losing the patience or the ability to keep up with payments on the property, which all but forces a lender’s hand.
“The more recent discussions I’ve had on [DPOs] is just lenders making the decision in the current market that they’re not seeing a lot of upside to going through the enforcement process,” Hatch said. “That would involve becoming the owner of those properties and trying to sell them at a better price.”
In addition to acknowledging a property’s loss of value, a lender could be convinced to agree to a DPO because doing so would free up some capital to make new loans, Morgan and Hatch said.
Even so, extensions and short-term forbearance agreements are still the most common resolutions being reached this autumn, as the holidays rapidly approach and complex deals seem less likely to get done before the end of the year, sources told Bisnow. But the longer lenders delay their final decisions, the more appealing DPOs could become.
“We’re starting to see more banks calling us, saying, ‘Uh-oh, we should have sold that loan a year ago,’” Cannon said.