Possible CRE scenarios going forward
Similar to previous downturns in the CRE sector (notably, during the GFC and amid COVID-19), we expect loan special servicers to grant loan modifications and extensions to troubled borrowers as long as the latter can demonstrate a willingness to work with the servicers. Still, deal sponsors will likely need to contribute their own capital to help support underperforming assets, which may cause many of them to walk away from the properties (as we have seen with a few high-profile office loan defaults recently).
The special servicer “playbook” was successful during the GFC and COVID-19 because the CRE sector downturns were temporary. The risk case this time around is that the slump could prove deeper and more lasting for the office segment (similar to what we saw in retail), leaving many borrowers reticent to pony up fresh capital. On the positive side, loan maturities have typically been a catalyst for an uptick in defaults, and there is fortunately not a large number of loans scheduled to mature this year.
We believe borrowers who locked in cheap fixed-rate financing at low interest rates will be incentivized to extend their loans in order to buy time for borrowing costs to come down and lending conditions to improve. Borrowers who took out floating-rate loans, however, are already grappling with “payment shock” from higher rates and may thus be hard-pressed to meet the performance hurdles required to extend their loans (e.g., debt-service coverage ratios). Additionally, these borrowers would have to purchase new interest-rate caps for an extended loan period, which have become quite expensive following the sharp rise in rates over the past year or so. These factors could explain why some floating-rate borrowers are opting to walk away from their properties.