Are you tracking the ongoing storm in the commercial real estate sector?
This is not a big surprise. It happens in some form or the other in every recession. But investors always seem perplexed.
While this recession probably won’t be as devastating as the Great Recession, there is one element that makes the problem more widespread. It is the fact that a much higher percentage of the investor population now invests in commercial real estate as compared to 2008.
Crowdfunding, social media, the JOBS Act, and the proliferation of new gurus (I call them “neuros”) have all contributed to the size of the crack in the ice that has already formed and is about to give way.
BiggerPockets facilitates an amazing community that has created education, connections, advice, and more. Communities like ours have also created avenues for investors and syndicators to connect with investment sponsors on a level investors could only dream of in years past.
And most of these investors have enjoyed handsome returns over the years. The rising tide has lifted almost every boat.
But with these great returns comes some risk. The concern is with new syndicators who have not seen the downturn taking undue risks because they have not experienced the pain of where these risks can lead.
What risk am I talking about here?
I’m talking about a mountain of commercial real estate debt that won’t be able to be refinanced in the coming year because of high interest rates.
How will it affect you?
Do you know what and how this will affect your investments?
In this disturbing report, Fitch Ratings claims that about 23% of CMBS debt maturing by the end of the year 2023 will not be refinanced under any realistic scenario. That’s $6.2 billion in CMBS loans alone. This doesn’t take into account agency loans and other types of private commercial real estate loans, which can be huge.
three terrible choices
According to a Fitch Ratings report, this leaves many syndicators with three unpleasant options for how to proceed:
- increase net operating income Up to 50% from the time of acquisition till loan maturity.
- authorize capital call To remove these properties.
- hand over the keys to the lender.
option one Possible but unlikely in the coming year, according to recent flatter rent growth forecasts. Origin Investments claims they have excellent data on this front, and they forecast nearly flat rents in many markets through 2023. Brian Burke, Commenting on a recent Scott Trench postThat said the new rent growth projections show a significant slowdown for next year.
It’s not an option, something most good investors should rely on anyway. we have often warned About trusting the market for your returns. It’s not smart.
give option Asks unhappy investors to pour more cash into a sinking ship. This will dilute existing investor equity stake and may even cause existing investors to lose their equity as new investors seek a higher position on the totem pole.
option three clearly destructive. Sadly, this is already in process for many unsuspecting investors.
A syndicator friend of mine was at his lender’s office last month, and the banker showed him a thick manila folder. Currently executing loan That the bank has already decided that they will not refinance next year. These deals are very risky given the volatile economic environment.
It sounds unimaginable, but for those of you who were around during the Great Recession, you know it’s a sad reality. And many syndicators don’t even know they’re about to be attacked.
I warned about this situation in a recent article, and I hope my prediction was wrong. But I’m afraid I was right. I’m not saying this to ruin your day, but to warn you that current performance doesn’t mean that everything is fine behind the scenes.
now what?
There really isn’t much you can do about your past investments. But as we often discuss on How To Lose Money Podcast, it’s important to learn from our mistakes. Not just our own—but those created by others who play in our sandbox.
Lack of due diligence on operators and deals- One of the major mistakes that investors make all the time. And if you believe in Mr. Buffett’s most important rule of investing, you’ll rank “protection of principal” as your top due diligence priority.
While we generally discuss protection of principal in terms of choosing the right asset type, I advise you to think more deeply about due diligence. I urge you to carefully check the operator. This includes their team, their track record, their acquisition pipeline and more.
And I suggest you take a deeper look at loan structuring because the devil is in the details. Model the impact of short vs long term debt, LTC, LTV, DSCR, fixed vs floating rate debt, rate caps and hedges, cross-collateralization, prepayment penalties, subscription lines of credit, interest only tenors, rapidly reducing occupancy and income , and rising interest rates.
I believe it is also important to consider who the lender is, their experience with a particular asset class, and how they handled the 2008 crisis. We have walked away from deals based on concerns with certain operators and their debt.
It will not guarantee the success of your investment. Even investing in an all-cash/zero-debt deal will not guarantee safety of principal, returns, or investment success. Too many great looking deals have fallen through because of events beyond anyone’s control.
But I firmly believe that taking a conservative approach to asset choice, operator selection and especially loan creation gives you the best chance to succeed in an environment full of unknowns.
Risky lending is one of the surest ways to add great risk to a typically speculative real estate investment. Wherever and whenever you choose to invest, I encourage you to make operator selection and debt structure two of your non-negotiable investment criteria.
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Note by BiggerPockets: These are the views expressed by the author and do not necessarily represent the views of BigPockets.
