Firms focus on distressed properties

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Philadelphia-based law firm Ballard Spahr recently announced a new division in its Minneapolis office with an interesting name: Distressed Assets and Opportunities Group.

“Distressed” refers to property subject to financial difficulties such as bankruptcy and foreclosure.  “Opportunities” refers to strategies that can help distressed building owners and lenders stave off negative outcomes and come up with mutually beneficial solutions, such as refinancing, said William Wassweiler, an equity partner in Ballard Spahr’s Minneapolis office.

Nationwide, the distressed office properties category has grown as owners and lenders deal with a rising tide of loan foreclosures, in a time of record-high office vacancies and operating costs, and rapidly rising interest rates that further impact owners’ and investors’ return. As a measure of the potential damage, in 2024 more than $900 billion in commercial real estate debt is scheduled to reach maturity.

“We identified the [foreclosure] issue a couple of years ago as we emerged from COVID,”  said Wassweiler. The firm formed a multi-disciplinary team drawing from a number of areas of in-house expertise related to real estate and finance in the firm’s offices across the country. “It’s a very efficient way to address default issues.” So far,  the group “has been very helpful in my practice and to my clients,” Wassweiler said.

In addressing property foreclosure issues, the idea is to help clients sort through the possible options for resolving issues that could lead to foreclosure by “helping them go through a decision tree.” Restructuring debt is one of the commonly used remedies in an environment in which “higher interest rates make refinancing more of a challenge. It’s also more challenging when you’re seeking to sell collateral as a remedy to default.”

Brian McCool, chairman of Minneapolis-based Fredrikson’s real estate and construction practice, said that in the current market, lenders are more likely to negotiate debt restructuring rather than taking back assets.

A major reason is that lenders generally recognize that the current, developing problems in the office market are market-driven and not caused by irresponsible behavior by borrowers or mortgage lenders, he said. Lenders generally recognize that rising defaults in the office market have been caused by rapidly rising interest rates and slipping demand. As a result, “lenders are working with borrowers to come up with better outcomes than foreclosing,” McCool said.

Also, Class A properties continue to benefit from a “flight to quality” among space users, he said. Owners of Class A buildings are often better positioned, with less debt and stronger tenant rolls, than those who own lower-quality buildings.

“Tenants still need space to occupy, so the ‘cream of the crop’ are going to continue enjoying success with what demand is left. That doesn’t mean they won’t feel some pain, too, but Class A could be positioned better to weather the crisis in the short term.”

The remedies available to lenders and owners to resolve problems haven’t changed or evolved much since the last downturn in 2008-2009, McCool noted. “What is different is the lessons learned in the Great Recession. Pulling the plug on borrowers is not always the way to maximize returns” for owners and lenders. “Patience and cooperation can lead to better outcomes for all than ‘scorched earth’ foreclosure litigation.”

During an extended period of historically low interest rates, “a lot of deals were done with valuations and loan terms that were reliant on those low rates. As interest rates go up, they ‘pinch’ values, and if rents don’t go up there is less cash to pay the bank every month,” often leading to mortgage defaults.

The one-two punch of slipping demand for office space and higher interest rates  can cause buildings to lose value, “with more cash going out and less cash coming in,” McCool said.  On the plus side, those lower values can attract more potential buyers looking for buildings being offered for sale at less than their historical value. “When you get into a distressed asset environment, other types of investors come into the discussion – mainly funds and investors who are looking for great value,” he said. “We saw a lot of that 10-12 years ago, with some investors in distressed properties doing quite well.”

Coming out of the pandemic, a similar dynamic occurred in the hospitality sector, McCool said. “After people stopped traveling [due to Covid], we saw a lot of hospitality properties. Investor pools were formed to pursue those distressed assets, and values in the hospitality sector have started to return.”

Class A office buildings with sought-after amenities are better positioned to weather the downturn than lower quality properties, McCool pointed out.

With office buildings losing occupancy and slipping into the “distressed” category, “there is going to be a lot of capital out there that will pursue deals; not the normal names you see investing in Class A” — pension funds and similar institutional investors, McCool added.

With the work-from-home trend that has impacted office space, “that doesn’t mean we can’t have a healthy office market long term. Office leases have long terms, 10 to 15 years, and we’re only about three years into the post-pandemic,” he said, “So there are still a number of office tenants who have more space than they need, and we’re going to see  adjustments. It also means we’re probably not going to see a whole lot of new buildings being built for some time.”

Brad Williams, a partner in Dorsey & Whitney’s real estate and land use practice group, also said he has been seeing a more cooperative attitude between borrowers and lenders. Some have working relationships that date back to the previous downturn of 2008-2009. “This time, they are more focused on office building forbearances, extensions and some creative solutions. Lenders don’t want to take back property; they would rather work with borrowers to come up with ways to allow the borrower to reposition property and market it in a more cooperative manner.”

And, “we do have more flexibility with property owners being able to negotiate ‘workouts’ with certain types of non-CMBS lenders. The matters I’m working on for clients are tilted more toward transactions than foreclosures.”

Williams has frequently been seeing parties coming up with “creative solutions” as alternatives to foreclosure.  “An interesting concept we’ve seen recently is participation, or ‘shared appreciation’ mortgages. This solution is rarely used, but it can make sense in some situations — larger, more prominent buildings with better prospects for being sold in a difficult market.” Another option is when the lender allows some sort of seller financing in connection with a sale, Williams said.

Some property owners have been exploring converting office space to other purposes, such as residential, he said. “But those are more difficult, because of the capital investment required and the difficulty of finding tenants for those new uses in a higher rate environment.”

Correction: This article has been revised to accurately quote Dorsey & Whitney partner Brad Williams.