Mounting Commercial Real Estate Debt Has The Potential To Destroy Portfolios—Here's What You Need To Know

Are you tracking the storm brewing in the commercial real estate realm?

It’s not a big surprise. It happens in every downturn in one form or another. But investors always seem to be surprised.

Though this downturn will likely not be as devastating as the Great Recession, there is one element that makes the problem more pervasive. That is the fact that a much higher percentage of the investor population invests in commercial real estate now compared to 2008.

Crowdfunding, social media, the JOBS Act, and the proliferation of new gurus (I call them “Newrus”) have contributed to the size of cracks in the ice that have already formed and are about to give way.

BiggerPockets has facilitated a wonderful community that has spawned education, connections, mentoring, and so much more. Communities like ours have also created paths for investors and syndicators to connect at a level investment sponsors and investors could have only dreamed about in years past.

And most of these investors have enjoyed wonderful returns over these past several years. The rising tide has lifted almost every boat.

But with this wonderful return comes a good bit of risk. The concern regards newer syndicators who haven’t seen a downturn taking undue risks since they haven’t experienced the pain of where these risks can lead.

What risk am I referring to here?

I’m talking about the mountain of commercial real estate debt that will not be able to be refinanced in the coming year due to higher interest rates.

How Will This Impact You?

Do you know if and how this will impact your investments?

In this troubling report, Fitch Ratings claims that about 23% of CMBS debt maturing by year-end 2023 will not be refinanceable under any realistic scenario. That’s $6.2 billion in CMBS debt alone. This doesn’t take into account agency debt and other types of private commercial real estate debt, which could be much larger.

Three dreadful options

According to the Fitch Ratings report, this leaves many syndicators with three unpleasant choices to move forward:

Raise Net Operating Income by 50% from the time of acquisition to debt maturity.
Authorize a Capital Call to deleverage these assets.
Hand the keys back to the lender.

Option one is possible but unlikely in the coming year, according to recent flatter rent growth forecasts. Origin Investments claims to have outstanding data on this front, and they project virtually flat rents in many markets in 2023. Brian Burke, commenting on a recent Scott Trench post, said that new rent growth projections show a significant slowdown for next year.

This is not an option most good investors should count on, anyway. We’ve often warned about trusting the market for your returns. It’s not smart.

Option two asks unhappy investors to pump more cash into a sinking ship. This would water down current investor equity stakes and could even cause current investors to lose their equity as new investors demand a higher position on the totem pole.

Option three is obviously devastating. Sadly, this is already in process for many unsuspecting investors right now.

A syndicator friend of mine was in his lender’s office last month, and the banker showed him a thick manila folder of currently performing loans that the bank has already decided they would not refinance next year. These deals are too risky, given the unstable economic environment.

This seems unthinkable, but for you who were around during the Great Recession, you know it is a sad reality. And many syndicators don’t even know what’s about to hit them.

I warned about this situation in a recent article, and I’ve been hoping my prediction was wrong. But I fear I was right. I don’t say this to ruin your day, but to warn you that the current performance doesn’t mean everything is okay behind the scenes.

Now What?

There’s really not much you can do about your past investments. But as we often discussed on the How to Lose Money podcast, it’s important to learn from our mistakes. Not just our own—but those made by others who play in our sandbox.

Lack of due diligence—on operators and deals—is one of the major mistakes investors make all the time. And if you believe in Mr. Buffett’s most important rule of investing, you’ll rank “safety of principal” as your top due diligence priority.

While we usually discuss the safety of principal in terms of selecting the right asset type, I recommend you think of due diligence in a much deeper way. I urge you to carefully scrutinize the operator. This includes their team, their track record, their acquisition pipeline, and much more.

And I recommend you look deeply at the debt structure because the devil is in the details. Model out the implications 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 periods, sharply decreasing occupancy and income, and increasing interest rates.

I believe it’s 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 quite a few operators and deals based on concerns over their debt.

This won’t guarantee your investment success. Even investing in an all-cash/zero-debt deal won’t guarantee safety of principal, profit, or investing success. Lots of great-looking deals have gone splat due to events outside anyone’s control.

But I sincerely believe that taking a conservative approach to asset choice, operator selection, and specifically, debt construction, gives you the best possible chance to succeed in an environment filled with unknowns.

Risky debt is one of the most certain ways to add outsized risk to a generally predictable 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.

New! The State of Real Estate Investing 2023

After years of unprecedented growth, the housing market has shifted course and has entered a correction. Now is your time to take advantage. Download the 2023 State of Real Estate Investing report written by Dave Meyer, to find out which strategies and tactics will profit in 2023.