The mantra “Location, location, location” intended to mean the three things that matter most in real estate should be replaced with “Valuation, Valuation, Valuation”.
Valuation is the foundation of a successful CMBS transaction and the key to setting expectations, from cash flow to recovery. This should be of paramount importance in times of economic flux, because when, as today, there is uncertainty and potential for losses, this is the area where parties to the agreement may be most vulnerable to legal claims. investors, including those related to special service practices, net operating income (NOI) and real estate valuations.
In fact, valuation issues are already at the center of litigation and impact the ability to refinance in a rising interest rate environment.
There’s an impending wave of $97 billion in CMBS loans maturing in the next 36 months, with $33 billion coming in the next 18 months. It’s a smaller wave than the big “deadline wall” of five years ago, but as I discussed with Real Estate Wealth Managementrecently, it could have a disproportionate impact given rising interest rates and likely increased costs and, at its core, it may create valuation uncertainty.
CMBS’s response to rising interest rates can be an indicator for the economy as cash flow is indicative of the health of so many sectors of the economy, from retail to manufacturing. So far, interest rate volatility has introduced additional uncertainty into the quicksand of a post-pandemic economy and, by extension, into the secondary market. As I mentioned in a recent interview with commercial real estate directorthe uncertainty for both lenders and borrowers is reflected in the widening of credit spreads and the sharp drop in new issues in June and July (since the start of the war in Ukraine), after a good start to the year .
(Bloomberg data, provided by Stout)
For the most part, there has been a steady improvement in delinquencies since the pre-pandemic peaks, but when it comes to interest rates, there is a tipping point when too high becomes too high and negatively affects the value of properties and the underlying performance of the credit. For conduit loans maturing with an average capitalization rate of 4-5%, analyzes have shown a good part of them can maintain an acceptable debt service coverage ratio (DSCR) and obtain refinancing at 6-7%. At higher levels, there is a greater chance that additional layers of more expensive debt will be required.
Eyes on office and retail
Across all sectors, there will be refinancing challenges for properties whose NOI is already low relative to existing debt. Not only are they maturing in a higher rate environment, but other costs are also rising, including the cost of insurance and maintaining the interest rate cap.
According to DBRS, by sector, retail and office account for the largest share of loans maturing in 2022-2023. These sectors have been tested and put to the test by the Covid. If there is a recession, as some have predicted by the end of 2023, then apart from rising interest rates, valuations may change, causing the NOI to fall below desired or sustainable levels for refinancing.
Particularly in the office sector, remote and hybrid working and the success of employers’ return-to-office plans will impact the availability of refinance or extension for a given property and the valuation of the impact. Potential changes in office use would exacerbate oversupply problems in general, but would have a disproportionate impact on older buildings, which could be even more difficult to refinance. Manny Malbari, co-leader of the Structured Finance practice, Valuation Advisory at Stout, notes a good example: “New York, where tenants are signing new leases with a smaller footprint in new buildings with better amenities than their space existing to attract and retain talent.”
The challenges are compounded by the fact that leases for some 900 million square feet of office space in the United States are expected to expire by 2025which could lead to a significant loss of value over several years.
Retail is facing further challenges from inflation, supply shortages and changing consumer preferences and will not stabilize as quickly.
The Special Distressed Loans Department can make or break distressed CMBS transactions. Gunes Kulaligil, Co-Head of Structured Finance Practice, Valuation Advisory at Stout, points out that “the objective should be to maximize value for the trust as a whole. The dollar amount and timing of recoveries are important if the way of disposition is chosen. However, various types of alterations may offer more value than the disposition of assets.”
Whichever resolution is chosen, it will be important to show that it is the “best” result for confidence. “The problem, of course, is that different parts of the capital structure will eventually get better or worse depending on how much it receives, when and what it’s called depending on the underlying deals,” Kulaligil warns. To complicate matters, service and second-tier bondholders can sometimes be affiliated or even the same entity “further emphasizing the importance of providing a clear rationale and NPV analysis for any resolution strategy”, suggests Kulaligil.
For Kulaligil, Icahn Partners v. Rialto Capital Advisors, LLC is a 2022 litigation in Nevada state court between certificate holders and a special repairer regarding a shopping center property demonstrating the critical role of appraisal and its impact on the legal exposure.
The complaint describes the underlying agreement as having a control transfer mechanism whereby holders of first-loss Class E certificates with more than 25% outstanding certificate balance take control once the implied losses are determined. This is rooted in the principle that the most exposed certificate holders should have control over what happens to the property that guarantees the certificates.
The plaintiffs are the Class E certificate holders who claim the special agent denied them control of the property by ordering artificially inflated appraisals that did not properly reflect the certificate holder’s implied losses. They allege that the special repairman’s maneuver was motivated by his desire to salvage the property and continue to operate it although a sale would have been the rational course of action to mitigate the certificate holders’ losses.
While the case is in its early stages, with a motion pending dismissal, it’s a storyline that shows the changing fortunes of a deal based on a valuation as interpreted within the framework of the contract.
Valuation will be a primary consideration given the turmoil in the market, particularly in the office sector. If performance weakens and there are battles over loss allocation, valuation disputes will likely be at the center. Market uncertainty and losses can sow fertile ground for disputes over projected NOI and occupancy levels, as well as the role of valuation in defining key lending ratios such as DSCR and ratio loan-to-value.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.