Current State of the Commercial Real Estate Market and Pending Loan Defaults
Today, dozens of buildings in downtown Cleveland are distressed or are “upside down,” meaning that the properties in operation are having difficulty paying or are behind in paying their mortgages. Commercial mortgage loans can also be “upside down” due to high vacancy rates, disappointing reappraisals or loan covenant defaults. Cleveland is not alone in this phenomenon, but impacted borrowers should be reviewing their loan documents carefully to determine whether they are in danger of triggering a default. Although a variety of tools are available to help borrowers and lenders navigate distressed or upside‑down situations, these measures do not always resolve the issue. In worst‑case scenarios, lenders can exercise legal rights to appoint a receiver to assume control of the property or to foreclose on their mortgage liens to maximize recovery.
When these mitigation strategies fall short, borrowers and lenders may be forced to rely on more formal legal mechanisms to address the situation. Receivership is a legal process in which an administering court appoints a neutral third party (the receiver) to take control of, manage and protect a property. This often results in the building being marketed and ultimately sold to a new buyer. Foreclosure is another legal remedy in which the lender forces a sale of a property to recover the outstanding loan balance after the borrower stops making payments. Once a property moves through receivership or foreclosure, it typically gets a fresh start under new ownership.
In order to avoid such severe lender remedies, borrowers should, among other things, review their loan documents, evaluate the general state of operations of the property and ask the following questions:
- When is the next test date for financial covenants and will the property meet those performance requirements?
- Under what circumstances can the lender order a new appraisal of the property?
- If the lender orders a title report, will it show any additional prohibited liens such as mechanics’ liens, second mortgages or tax liens?
- Are there any cure periods for events of default?
- Under what circumstances can the lender require a current rent roll and is cash flow from rents sufficient to support debt service of the loan?
- If the loan is in default, will the lender agree to a forbearance period in order to provide time to restructure the terms of the loan, such as extending the maturity date or adjusting the amount of the loan payment?
- What liability does a guarantor have in an event of default?
- Is it time to contact the lender to address the situation and negotiate a loan work out?
- Is it time to engage professionals to assist with navigating a loan work out?
What Can the Commercial Real Estate Market Do?
Although conditions in downtown Cleveland’s office market may feel discouraging, a viable path still exists from the current state toward the desired future. The question now is: what can (and should) be done?
The key to navigating through the current storm is establishing an understanding of what contributed to the situation at hand. The following factors have contributed to the current distressed market conditions:
- Evolving understanding of the importance of “in office” and “work from home” to a business’ competitiveness, productivity and profitability
- Office occupiers now often require new features incorporating technology, health and safety, and workstyle requirements
- Office occupiers and workforce preferences are ever changing
- Institutional barriers can hinder efforts to adapt to evolving corporate workstyles and workforce preferences
- Change is expensive – especially for buildings purchased and financed before the pandemic
- No one priced the costs for the renovation work needed to help existing buildings catch up with the current environment
- Occupier space requirements on a square footage basis have decreased while build out costs per square foot have increased
- Misplaced priorities driven by “noise” or distractions in markets hamstrung by limited data or processes for exchanging and distributing market knowledge
- Time value of money concerns are amplified in markets with inefficient institutional processes for handling distressed assets
The challenges outlined above are common to nearly every downtown market in the United States. So, what sets Cleveland’s path forward? Among all these factors, process efficiency is the one area where Cleveland can meaningfully intervene. Accordingly, Cleveland must take action across firms and institutions to rehabilitate and improve the existing market framework to upgrade how the local office market operates.
Why Real Estate Markets Struggle to Self‑Correct
Understanding real estate markets isn’t rocket science, but it does require some foundational knowledge. A market is where buyers and sellers interact through systems, institutions, procedures or infrastructures to transact goods and services. Some folks point to the efficient market hypotheses, assuming that information is quickly incorporated into pricing, that easy profit opportunities are rare and that excess returns are unlikely without significant risk. If the market will solve its way through the current situation, why bother doing anything? Some may equate the real estate market to the stock market, where rapid sharing of information and public transparency help participants continually incorporate risks and returns into pricing. However, by comparison, real estate markets are generally far less effective at translating risks and returns into accurate pricing because, to a large extent:
- There are significant and various transaction costs in trading real estate
- Reliable information is expensive to obtain (outside of single-family real estate)
- Informational asymmetries and disparities in information known by transacting parties abound – even when parties are assisted by recognized local “experts”
- There is little collective agreement on the implications for current pricing and expected future pricing outcomes
Uninformed real estate market outsiders may erroneously assume that there are no material informational asymmetries within real estate markets and that market participants have identical estimates of expected returns and risks. However, even in the early stages of the “AI age”, it is more than a stretch to make these assumptions given the complexities associated with ever changing macro and micro dynamics within real estate. These macro and micro dynamics involve issues related to the supply and demand for real estate from an occupier perspective, construction labor, construction materials and debt or equity investor capital, especially over time.
Real estate markets are far less dynamic than commodity, currency and stock markets. In a paper testing and confirming the efficient market hypothesis in the context of the stock market, Fama explains how markets work to price economic assets:
In general terms, the ideal is a market in which prices provide accurate signals for resource allocation: that is, a market in which firms can make production-investment decisions, and investors can choose among the securities that represent ownership of firms’ activities under the assumption that security prices at any time “fully reflect” all available information. A market in which prices always “fully reflect” available information is called “efficient.”
It goes without saying that less functional markets are more expensive and therefore less attractive. So, what can we collaboratively work on in Cleveland to make things better?
- Continue to unify and simplify institutional processes
- Coordinate across City and County offices to develop a regional system of flexible permit, occupancy and taxation policies for street level spaces within buildings
- Examine and change receivership and foreclosure processes with the goal of reducing the length of time properties are in receivership and foreclosure
- Establish standards for increased transparency and simple but actionable activity reporting from industry and institutions to better inform the local market on metrics ranging from parking, traffic, safety, sales and other activities
- Cultivate greater understanding of network effects across industry and institutions so that existing and planned utility, transportation, recreation, health and safety networks can be maximized
- Restore or build upon existing connections with surrounding and outlying communities built on road, rail, canal, lake, recreation, education or business networks
- Identify and develop individual or select groups of buildings as “nodes” or districts to house focused, complementary concentrations of firms and businesses
- Further expand on downtown special improvement districts and develop a system of broad-based, low-rate special assessments for non-profit owners devoted to enhancing downtown public infrastructure services and improvements
- Continue to develop data supported decision-making and process management frameworks that can translate to real results across industries and institutions
Next Steps
By modernizing processes, strengthening institutional coordination and improving transparency, Cleveland can position itself not only to weather current challenges, but to emerge with a more resilient, adaptable and competitive commercial real estate market
Contact
If you require assistance regarding loan workouts or have questions about options to improve your property’s position, KJK can assist with the development and execution of viable strategies. For more information on how we can help, contact KJK Partners Anne Corrigan (ATC@kjk.com) or Rich Morehouse (RAM@kjk.com).