Many of these investors have been stockpiling funds since early in the pandemic. They have been frustrated because most property owners haven’t agreed to sell at big-enough markdowns, in large part because lenders have been willing to offer loan extensions and modifications.
Now, that is starting to change. Lenders are stepping up the pressure on owners of office buildings crippled by remote work. They are getting tougher on hotel owners who have neglected repairs. They are calling in loans to apartment building owners who fell behind on construction schedules owing to supply-chain shortages.
Soaring interest rates are the main reason. Property owners who used floating rate debt or bought properties before the interest rate shock began in 2022 are struggling to afford higher debt-service costs, which often are more than 4 percentage points higher.
Investors with cash on hand have begun to snap up these properties or provide rescue capital to struggling owners in exchange for preferred returns. Recent activity includes deals by a venture of investment giant Ares Management and New York office landlord RXR. The venture is buying discounted interests in 3 million square feet of office space and has made offers on more than $500 million worth of senior debt, according to a person familiar with the matter.
“We’re in a period of time where it’s great to have dry powder,” said Rich Banjo, co-president of Artemis Real Estate Partners, which has been buying distressed properties through a $2.2 billion fund it closed last year.
Overall, global real-estate funds operated by private-equity firms were sitting on $544 billion in cash as of the second quarter of last year—a record level and up from $457 billion at the end of 2022, according to data firm Preqin. The largest increase was in so-called opportunistic funds, which often search for distressed opportunities.
In some cases, property owners have to replace construction loans obtained from regional banks. These lenders are coming under increased scrutiny after New York Community Bancorp slashed its dividend.
In the past, regional banks often provided loan extensions to developers of completed projects even if they were behind schedule in leasing up. But these days, regulators are warning these lenders that they need to reduce real-estate exposure, and regional banks are pulling back.
Take the case of Harbor Group International, which has spent more than $600 million over the past year on seven apartment building developments—including Palm Ridge and Locklyn West Palm, both in Palm Beach, Fla. Some of the properties it purchased weren’t leasing up as quickly as expected.
“Given the pressure on regional banks, those extension options were not necessarily available to developers,” said Richard Litton, president of Harbor Group, which is based in Norfolk, Va.
As of the end of 2023, commercial property distress, including financially troubled assets and those taken over by lenders, totaled $85.8 billion, according to data provider MSCI Real Assets. That is up from $56.9 billion at the end of 2022 and the highest level since the third quarter of 2013, MSCI said.
Analysts expect that distress will keep rising in the years ahead as more owners need to refinance. More than $2.2 trillion in commercial mortgages are scheduled to mature between now and the end of 2027, according to data firm Trepp.
“At some point, that avalanche is going to hit,” said Lonnie Hendry, Trepp’s chief product officer.
The rise in distressed sales promises to help stabilize the commercial property market at a time when sales volume has plummeted owing to higher borrowing rates, and weaker cash flows for some property types. That decline has made it much more difficult to determine current values. But as distressed deal activity increases, new values will emerge, albeit at lower levels.
Big names are getting into the distressed game by making loans to troubled landlords or injecting fresh equity. SL Green Realty, New York’s largest office landlord, said last month that it planned to raise a $1 billion opportunistic debt fund focusing on the city.
Some of the early distressed deals have involved properties whose pandemic-related problems were compounded by higher interest rates. With a $1 billion fund it closed at the end of last year, Atlanta-based Noble Investment Group has purchased 25 hotels, many of them hit by the one-two punch of deferred maintenance during the pandemic and higher rates, according to Mit Shah, Noble’s chief executive.
In one of the largest distressed deals, the Federal Deposit Insurance Corp. in December agreed to sell $17 billion worth of loans seized from the failed Signature Bank to a venture including Blackstone Real Estate Income Trust in a deal that valued the portfolio at about $12 billion. The group is now marketing loans in the package to other investors, according to a person familiar with the matter.
Commercial property pain is still far from the levels of the 2008-9 financial crisis. In the second quarter of 2010, the industry was swamped with a record $194.8 billion in distress, $109 billion more than at the end of 2023, according to MSCI.
Moreover, there is more capital available from funds and other sources to buy distressed assets or provide new loans or preferred equity. Many owners are also reaching into their own pockets to salvage their deals.
Largely because of this available capital, special servicers of troubled commercial mortgages that were converted into securities were able to work out $11.2 billion worth of loans last year, up from $5.2 billion in 2022, according to Trepp.
During the financial crisis, “loans came into special servicing but they didn’t leave,” said Alex Killick, managing director at CWCapital Asset Management, one of the largest special servicers. “The difference this time is that loans are definitely coming in, but they’re going back out as well.”
Still, if higher interest rates persist, many owners struggling to hang on might eventually have to capitulate.
“Just because you can secure some equity or you can get an extension, doesn’t change the underlying dynamics,” said Hendry. “At some point, the math is just the math.”
Write to Peter Grant at [email protected]
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