The near-term outlook for commercial real estate (CRE) has become increasingly complicated due to rising interest rates along with lingering fears of a recession. Banks today are facing a greater pressure on CRE Asset valuations (on their Balance Sheet) as higher interest rates have resulted in tighter credit standards with regulators more closely monitoring the quality of CRE loans.

A tighter lending market, along with declines in real estate investment trust (REIT) stocks, have negatively affected yield expectations on CRE and price declines / distress in certain asset classes are underway. Due to decreasing asset values, some properties coming up for refinancing today may have trouble obtaining a new mortgage sufficient to replace the one that is maturing.

In addition to this, as employers who occupy CRE continue to adopt hybrid work policies, demand for office space is softening, resulting in higher vacancy rates and sublease space volumes. The has placed downward pressure on effective rents and has extended the time to lease vacant space on the market and within the post-pandemic office landscape, these trends are notably evident in older, Class B office properties. While the office market seems to carry the highest risk, other asset classes are not immune to a weakening economy.

We have provided some strategies for owners of impacted real estate assets to consider to navigate the uncertainty ahead and could be used individually or combined to be effective:

(1) Debt Modification: Borrower-lender negotiations should be considered at the outset to address issues with CRE being held. Typically, the Owner should attempt to get a 2-3-year loan extension to buy time with % paydown. This is a Short-term solution that could help “buy time” and if both parties can come to an agreement and this situation can be re-evaluated in a few years.

(2) Recapitalization: Another strategy is to attempt to replace existing capital structure if the stockholders (in case of a REIT) can be convinced that this course of action is in the best interest of all parties. However, this is medium-term strategy which could be considered with impact of transaction market halted with no pricing discovery.

(3) Asset Repurpose: Conversion can be considered i.e. to redevelop for alternate use of this property e.g. work to change Office Space to Apartments. However, this is a longer-term solution, and the Basis of underlying asset must be low with favorable city incentives in place to make this transaction work

(4) Foreclosure: This should be considered as a last resort since Collateral (property) goes back to lender and is an extreme Long-term solution. It may be worth noting that the note or collateral will likely be sold before collateral seized resulting in a significant financial loss

Impact of Taxes

Throughout the process of considering loan restructuring alternatives, it is essential to consider the tax implications of each scenario for borrowers and lenders. Debt modification, asset repurpose, foreclosure, acquisition of a distressed loan and cancellation of debt income all have tax consequences for the borrower and in some cases the Lender also. Any significant restructuring could be viewed as a taxable transaction and trigger a tax liability requiring a cash payment from the borrower, which could make a distressed situation even worse.

Hence, in our opinion, Legal, financial, valuation and tax consequences of potential actions must be carefully vetted, with upside and downside scenarios thoughtfully considered. And above all, keeping the lines of communication open is an essential factor for success. Lenders, borrowers and investors must work toward mutually beneficial outcomes to optimize the interests of all parties involved.

Disclaimer

Please note that article / blog post is for informational purposes only, and is not intended to provide, and should not be relied on for Accounting, Financial, Retirement, Legal and/or Tax advice. Consequently, the information provided here does not constitute any form of Accounting, Financial, Retirement and /or Tax Advice and we strongly urge you to work with an Accountant, Lawyer, Financial Planner and/or Advisor to create a plan to manage your finance and taxes according to your circumstance and needs.