Commercial real estate assets in major markets such as New York City, Washington, DC, Boston, Chicago, Los Angeles and San Francisco have experienced a strong rebound in values and are being transacted near, or above, their pre-recession peaks. In contrast,  real estate assets outside of major markets and within certain asset classes (e.g., retail and suburban office) are experiencing more limited demand, often causing values to remain substantially below the pre-recession peak, as illustrated by the figure below. 1  

Figure: Moody’s/RCA Commercial Property Pricing Indices (CPPI)

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Higher prices on real estate assets have been supported by a combination of low interest rates and increased demand from foreign and domestic capital sources as investors continue to search for high quality real estate investments that provide attractive returns in comparison to low returns from fixed-income investments. The market preference for post-recession real estate investment has been in the major markets where underlying demand is strong, values are durable, and there are high barriers to entry.  However, these markets represent a minority of the commercial real estate market. In fact, central business district (CBD) office properties in major markets only comprise a little more than 10 percent of the 10.5 billion square feet of national office space. Similarly, retail properties in major markets are less than 25 percent of the 12.6 billion square feet of total national retail space. Hence the vast majority of the commercial real estate assets are located outside the major markets which have garnered attention for substantial increases in price.

Although real estate investment demand has increased to select secondary markets, such as Denver, Portland and Austin, it is not widespread. Over the next few years, challenges and opportunities will begin to emerge as real estate debt secured by assets in these secondary markets – debt that was originated during the pre-recession boom years – matures.

Performance by asset class: national overview

Although every asset is unique, a brief review of differences by property type reveals certain performance trends that will likely impact refinancing.

  • Hospitality – with continued strength in the hospitality sector, borrowers should have rising average daily rates (ADRs) and occupancy rates to facilitate refinancing. The hospitality sector is, however, highly cyclical and tied directly to macroeconomic performance.
  • Office – recovery in the office sector has been slow and uneven, with enormous upturns in primary markets such as New York and San Francisco, and lagging recovery in secondary and tertiary markets. Also, there are fundamental shifts in how firms will use and allocate office space such as continued migration to shared offices, teleworking, or simply a reduction in the amount of space leased/used that will reduce the future demand for space.
  • Industrial – the industrial sector should see improving fundamentals, but again the prospects for refinancing vary substantially market-by-market.
  • Retail – the retail sector is certainly the most precarious. While the sector has been buoyed by increased consumer confidence and spending, the outlook remains poor due to macro market changes and tenant contractions and bankruptcies. Beyond that, certain retail concepts (e.g., power centers, unanchored specialty centers, and non-dominant regional malls) are waning, so obtaining debt or equity capital of any amount will be a challenge.
  • Apartments – the apartment market has been the darling of the industry over the past three years. Available capital of all types will likely make refinancing fairly easy in most cases. That said, the availability of capital has caused a building boom and the resulting increase in supply could lead to overbuilding in some markets.

Impending commercial real estate mortgage maturities

An enormous wall of ten-year commercial real estate mortgages that were originated during the real estate boom of the last decade will mature between 2015 and 2017. More than US$1 trillion of commercial real estate (CRE) loans are estimated to mature during this three year period, with approximately 25 percent of the maturing loans packaged as commercial mortgage-backed securities (CMBS).  The vast majority of these loans were underwritten at a time when lenders were generally more aggressive and had eased their lending requirements to increase originations.

These CRE loans are maturing in a market where, despite substantial economic improvement, lenders are more conservative in their underwriting standards; generally requiring loan-to-value ratios (LTVs) based on in-place income streams instead of optimistic forecasts.  Thus, the fundamental question presented by the confluence of these events is whether these loans will be able to be successfully refinanced in today’s lending environment without substantial new equity investment. Additional pressure exists due to the fact that many of these loans are in locations outside of the major markets as preemptive transactions have already dealt with most of the impending maturities in those markets.

Furthermore, the period of low interest rates could be coming to an end given that the Federal Reserve ended its quantitative easing bond buying program in October 2014. Both short-term and long-term US Treasury interest rates are likely to rise as a result, creating upward pressure on all interest rates at the same time a large volume of loans need to be refinanced. Needless to say, increasing interest rates will have a pronounced effect on capital markets and the value and performance of real estate investments.

The final complicating factor when it comes to refinancing 2005 – 2007 vintage loans is the proliferation of the slicing and dicing of the debt and capital stack during this period; increasing the stakeholders to include junior lenders, mezzanine lenders and preferred equity owners. The massive amount of opportunistic real estate capital available over the past few years has allowed many of the original debt holders to sell their interest to real estate private equity firms or other investors. These new investors often have a different basis, objectives and mind set, making resolution more difficult and complicated.

The new face of the commercial lender

Currently, more than 90 percent of commercial mortgage debt is originated by commercial banks, CMBS conduit lenders and insurance companies, and it is these three groups that largely control the loans at issue.  As the existing pool of CRE debt matures, the commercial banks will be confronted with an interesting paradigm. On one hand, with improving balance sheets national and regional commercial banks will have an increasing ability to pursue additional commercial real estate lending. On the other hand, the continued regulatory pressures from Dodd-Frank and Basel III will make commercial real estate loans more expensive to originate and hold and that increased cost will be passed through to the borrower. In the end, it is likely that commercial banks will pursue a “flight to quality” strategy. They will continue to lend into high quality situations with limited risk, including refinancing many of the quality real estate assets in competitive markets, while looking for ways to exit less attractive situations.

The volume of new CMBS issuances has improved substantially from its low of about US$3 billion in 2009 to nearly US$100 billion in 2014. However, it is not viewed as likely that it will be able to return to anywhere near its pre-recession peak of US$230 billion in 2007. Finally, the life insurance companies will provide their typical mortgage origination volume of around US$75 billion, likely gravitating to less risky trophy assets (e.g., large, prestigious office buildings in major markets with strong tenant and owner profiles) unless they get pushed out by other lenders.

With the enormous amount of capital available, groups beyond regulated depository institutions and insurance companies such as private equity funds, REITs and other “lenders” are poised to potentially fill the increasing lending gap. For example, private equity funds continue to raise billions of dollars, with substantial amounts earmarked for real estate debt situations. In fact, Preqin reported that 26 new closed-end real estate debt funds raised US$20 billion during 2014, in addition to the capital already focused on debt investment. It is likely that these private investors will move more quickly to exercise remedies upon a default, and in certain situations treat the debt as nothing more than a “loan to own” strategy.

Strategies for addressing the complexities of the subordinated debt or equity ownership

In many commercial real estate investments, the equity owner or subordinated lender is a non-US investor.  With the passage of the Foreign Investment in Real Property Tax Act (FIRPTA), most of the foreign owners have opted to hold their equity interests in domestically controlled private real estate investment trusts (DCREIT).  In order to avoid US tax liability, the foreign investor must ensure that the DCREIT meets a number of requirements, including stock ownership and control tests.

The presence of FIRPTA and the structures embodied in the DCREITs create additional challenges for foreign investors in dealing with commercial real estate assets where the loan will be maturing. This raises questions about the ability to refinance the existing debt or the new lender in the event that the incumbent lender sells its position to a non-traditional financing source.  

Conclusion – what should you do?

With this fluid and complex situation, there are several guiding principles that foreign investors need to consider. First, it is important to remain diligent regarding the financial and operational performance of the asset. The uneven recovery makes achieving net operating income (NOI) growth difficult, but not impossible, and a strong performing asset is easier to refinance. The majority of investors have considerable rights regarding both monitoring financial and operating performance, and affecting changes to the extent necessary in management of the assets. Thus, investors should use all of their rights to ensure that their asset, even in an underperforming market or sector, is economically performing. If the investor doesn’t have the necessary skill set, there are professionals in the market who can assist the investor in this crucial role.

Second, begin monitoring the capital stack in the investment to understand not only where you “stand” but what the rights and obligations are of the other investors, both senior and junior to you. In doing so, be wary of distressed investors seeking to buy-out participants at a discount, as too often their “loan to own” strategy will seek to eliminate junior debt holders or simply complicate a restructuring. On the other side of this equation, look for opportunities to move up in the capital stack by either purchasing the senior debt, filling an equity cap or finding a “friendly” investor to do the same.           

Finally, begin all of these efforts now, while interest rates remain low and the macro-economic situation is better known. It is never too soon to begin exploring refinancing options, and it is far better to do this with time and optionality on your side, then when the asset is at or near default, and the strategies are far more limited, risky and expensive.

*Bruce Gamble is a Managing Director in Navigant’s Global Construction practice, based in Washington, DC. Reach him at