In January 2023, the commercial real estate market was subject to the impacts of higher interest rates and an increased awareness of the possibility of a recession. Interest rate increases, combined with inflationary pressures has left a negative impression on lenders and investors. In response, lenders and various financial institutions are bracing for the impact throughout the market. Opinions vary and change as financial indicators fluctuate. For example, in the last quarter of 2022, JP Morgan Chase’s Head of commercial finance, predicted a likelihood of recession higher than 50%. In a turbulent economy, where do investors turn to incentivize capital deployments (often defined as investments) in commercial real estate investments? One solution is to rework the original deal so every party’s needs are met. The alternative, and often more consequential approach, is preparing for foreclosure. Attorneys in the real estate field are capable and poised to face the challenges ahead and guide the transition of a new vision for commercial space.
Market reactions have caused commercial real estate prices to decrease at a rate not seen since the aftermath of the great recession in 2010. This includes corporate real estate prices as well. Experts from Real Capital Analytics (RCA) have attributed the 2023 price drops to increased mortgage costs, which spiked in 2022. RCA’s Commercial Property Price Index (CPPI) in January, recognized a “National All-Property Index [drop] [of] 4.8% from a year ago and 2.7% from December 2022.” The CPPI noted, this “monthly drop, when annualized, would be a decline of 27.9%.” This impact is expected to further decrease deal flow throughout 2023. Coldwell Banker Richard Ellis, one of the world’s largest real estate investment firms 2023 U.S. Investor Intentions Survey, found that roughly 60% of investors are anticipating they will lower their commercial real estate investments in 2023. In comparison only 15% expected to increase investments. With investors less willing to deploy capital on commercial real estate projects, borrowers are left with unmatched financing needs.
Real estate financing often uses secured lending for projects. These projects involve financing where the borrower acquires funds from lenders, and pays back the owed principal and interest through the investment. The attractiveness of an investment relies heavily on the ability for the real estate, serving as collateral for the loan, to generate revenue. Lenders often relying on funding from investors. One key underlying revenue generator from such investment is rent revenue. In order for the underlying real estate to generate such revenue, tenants must make timely and consistent payments. Borrowers often rely on this revenue to attract financing through equity investors.
However, a potential recession, inflationary pressure, and the lingering effects of the Covid-19 pandemic, has left both commercial estate purchasers and investors in a peculiar place. Covid-19 created the necessity for remote work, but an increasing demand from employees to maintain remote work opportunities has complicated the use of commercial office space. This demand combined with the heightened interest rates due to QT create for increased financing obstacles that attorneys must overcome in the loan negotiation process. Strained corporate balance-sheets are causing a limitation of tenants and is reducing the ability for adequate rent payments, putting investor returns at risk. With these issues in mind employers may choose to move from amenity-heavy, class A commercial office space, to hybrid-work-friendly, class B spaces.
To meet these changes, clients must maintain firms who are positioned to handle market fluctuations. The limitations on borrowing, lack of investor demand, and cost of refinancing will all play a major role in how law firms adapt for their clients. Defaults on mortgages are becoming a central focus of the market as these pressures increase. Mortgages are the most common type of security used for real estate financing. If the combined inflation, interest rates, and potential recession result in an increase of mortgage defaults, then the next practical, and often necessary, steps are to position the lenders, borrowers, and investors alike for workouts or foreclosures.
Workouts, which are an attempt to avoid foreclosure, occur in three main stages: (1) memorialization, (2) negotiation of a temporary forbearance agreement, and (3) ending forbearance. (1) Puts in writing the default by the borrower. (2) Sets a plan for the continued or renegotiated payment schedule on a loan. (3) Determines the final step where a cure of a default may resume the original payment schedule or a takeout purchaser is found to adhere to any covenants and transfer of the loan itself. It is likely these tools will need increased utilization throughout 2023. Foreclosures may increase as well. Foreclosures are the termination of a borrower’s interests in collateral, which is hoped to be avoided for borrowers and lenders, especially when the property is not easily convertible for other uses.
An increasing outcome of these challenges is an adaptation to a new vision for commercial property. As equity investors pull back on capital deployments, they may find an interest in the conversion of old office space, which had been acutely affected by the decrease in demand. Older office spaces lack the amenities attractive to many employees who embrace the hybrid-work model. Modern tenants expect office spaces to provide updated and sustainable features. In quarter 3 of 2022, vacancies hit a 30-year high at 17.1% for commercial properties. However, conversion rates are seeing an upward trend, which may provide and new hope for borrowers, lenders, and investors. Although this trend continues, its pace is slow. In fact, the current planned office space conversions for 2022, in aggregate, would have only converted 2% of the U.S. office inventory. Law firms will need to be prepared for increased conversions of such office spaces, all while managing the borrower, lender, and investor relationships.
Although 2023 will pose a multitude of difficulties for the market, it may be marked as a transition year for commercial real estate. Law firms are recognizing the needs of their clients, and have the proper tools to help manage the transition to a new use of commercial space. While prices fall, and demand decreases, 2023 may be looked back on as a crucial period for commercial office space. The modern office will have to adapt to the modern worker in an unprecedented way to meet all interests involved in the transaction. It is now evermore exciting in the legal field, overcoming the challenges of 2023 will likely set a strong precedent for years to come.
Cody Wlasuk is a second-year law student at Wake Forest University School of Law. After graduating cum laude from Framingham State University in 2018, Cody worked as a financial planner in Massachusetts, focused in debt finance. At Wake Forest, Cody joined the Board of Editors for Wake Forest’s Journal of Business and Intellectual Property Law. Upon graduation, he intends to practice in finance and real estate law.
Email: [email protected]