Managing Distressed CRE Loans to Minimize Lender Loan Losses

Mr. Alan JovinellyGreat article from Alan Jovinelly, CPA, SVP at Stockton Real Estate Advisors and former FDIC and OCC bank examiner. He strongly recommends to financial institutions, to survive the pending real estate banking crisis, they need to consult with their trusted real estate professionals to evaluate their options and plan their next steps in advance before it receives the “Jingle Mail”, bankruptcy threat, or I can’t pay the mortgage call. 

Managing Distressed Commerical Real Estate Loans To Minimize Lender Loan Losses

The next recession/banking crisis has been highly anticipated by lenders. Fueled by the Covid inspired low interest rate/easy money environment, all asset classes – especially office buildings, have reached “bubble” valuations and today we are about to pay the price with the next banking crisis. Despite prudent pre-covid lending practices, lenders are under tremendous pressure to trim their exposure to office building and construction loans. It is estimated that $1.5 Trillion in commercial real estate mortgages will mature within the next 2 years, a potential time bomb due to the unprecedented Federal Reserve 12-month 500bp interest rate increase and rapidly declining property NOI/DSCX/LTV will trigger massive loan defaults as office building owners are unable to substantially paydown their loans to obtain short-term extensions.  Largely unknown to the public, to avoid another “overnight” Silicon Valley Bank failure, the OCC and FDIC are already marketing at-risk banks and their loan portfolios to assuming banks. The FDIC has already started forming bad bank liquidation facilities for failed bank loans that cannot be sold.

Lenders should already be consulting with seasoned real estate professionals and evaluating the potential exit strategies for every office building loan. It is critical for lenders to evaluate each distressed loan/office building as a unique risk profile. Some are Class A or B+ quality which may be experiencing positive leasing activity as tenants move to quality to attract employees back to the office. Some will have strong financial backing and/or guarantees or low enough LTV’s to protect the lender.  But unfortunately, due to the unforeseen interest rate, operating cost & vacancy increases, all office building values will fall from 20% to 50% causing almost every 65%-75% LTV loan to be at risk. Many Class B, B- or C office building values are in free-fall and valuations will not stabilize for several years. Several will be permanently mothballed or demolished. Cushman & Wakefield’s Office Q1 2023 survey reported Philadelphia MSA office vacancy increased to 19.8% with over 1 million sf of negative absorption during the 1st Q2023. This vacancy does not include the inestimable “ghost” or “dark” tenant unoccupied space which will significantly increase vacancy levels for the next several years.

What options does a lender have if an important borrower defaults or calls to advise it can no longer pay its monthly debt service or threaten to play “jingle mail” and send the lender the keys if the lender refuses to forebear on its debt or grant substantial loan concessions?  It is critically important for each lender to be up-to-date in its surveillance of the quality of the rent rolls, building condition, project stabilized DSCX and the financial strength of the borrow/guarantors and to be ready now to answer these questions – before the lender gets that call. How can professional real estate managers and brokers help lenders limit their losses?

Professional real estate managers and brokers can help lenders by:

  1. Evaluate borrower performance and reputation.
    Is the owner actively engaged and professionally operating the property? Is the property actively marketed and does the owner have the necessary financial resources to reinvest in the building and sign new leases? Is the property well maintained or does it have serious operational deficiencies? Does the borrower have a good or bad market reputation?
  2. Assess the strength of the rent roll.
    Do any of the existing space have substantial unused space? Is the building’s parking lot underutilized relative to the building’s reported occupancy? Are any of the tenants in the market looking for space? What is the probability of tenant’s renewing, requiring major rental concessions, downsizing their space requirements and requiring substantial TI to reconfigure or update spaces?
  3. Assessing the property’s long-term viability.
    Is it well located? Can it be released and stabilized? Can operating costs be reduced and the real estate taxes assessments appealed? Can a key tenant be retained? Does the building have substantial deferred maintenance (roof, HVAC, common areas, etc.)? Can the property be converted to apartments or warehouse?
  4. Real Time Valuation.
    Broker BOV’s more accurately value properties in “real time” based on their market knowledge of what tenants are in the market and what buyers are willing to pay and sellers are willing to sell. Appraisers rely on historical sale and rent comps and are typically 12-18 months behind any dramatic market condition change. Currently the commercial real estate market is frozen because sellers cannot sell due to debt constraints or hope rapid interest rate reductions will save them and buyers need to see ‘blood in the streets” before they buy.   At this juncture, appraiser valuations tend to be either too high based upon historical comps, or too low based upon projected worst-case scenarios.
  5. Evaluate Exit Options.
    Will a loan forbearance/extension result in a better recovery than a loan sale, deed-in-lieu, tri-party sale, foreclosure sale, foreclosure/reposition/sale?  Are there any potential environmental issues? Can the lender pursue the bad boy guarantees?
  6. Provide Receivership (bankruptcy/foreclosure period) and/or Property Management (deed-in-lieu/repositioning/sale period).
    Protect lenders from borrower fraud, theft of tenants or loss of tenants due to inability to pay commissions, TI or fix deferred maintenance. Identify and start the execution of a well-defined value-add plan to maximize lender recoveries on these distressed properties.
  7. Brokerage services to maximize the sale of each property.
    There is also one wild-card the real estate banking world must consider. Many commercial loan rates float but both banks and borrowers are protected by third party interest rate caps or swaps. Given the unforeseen and unprecedented 500bp interest rate increase in one year, can these third-parties continue to honor their obligations or will they default and cause a severe banking crisis similar to the CMBS implosion in 2007- 2009?

 Based upon my meetings with many of the Philadelphia Regional Banks, all of the lenders have intensified their surveillance activities on all commercial real estate loans – particularly commercial office and construction loans. But unfortunately, in this pending bank crisis, great loan surveillance is not enough. To substantially mitigate losses, protect shareholder value and survive the pending real estate credit crisis, lenders need to immediately enhance their surveillance activities by consulting with trusted real estate professionals to evaluate their options and plan their next step in advance before it receives the “Jingle Mail”, bankruptcy threat, or I can’t pay the mortgage call. 

Writer Bio:

Alan Jovinelly, SVP Stockton REA is a CPA and 45-year real estate/banking executive who in 1991-1995 was one of the FDIC’s top-performing liquidation loan portfolio managers; from 1995 to 2009 was one of GE Capital’s top-performing distressed loan and equity portfolio managers; from 2010 to 2012 was Capmark Bank’s SVP for REO Sales; and in 2012-2013 was an OCC Industry Credit Expert – Commercial Loan Examiner. He also has 20-years’ experience as a developer or broker in various senior capacities and is highly skilled in debt workout negotiations, real estate tax appeals, property repositioning, value-creation and property sales.

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