Debt funds and other commercial real estate lenders prioritize refreshing collateral valuations for legacy loans

The evolving landscape for debt funds and other commercial real estate lenders

Central Banks – the U.S. Fed now included – have made important moves to switch gears from tightening monetary policy to easing up on “higher for longer” interest rates. The commercial real estate industry may be breathing a collective sigh of relief for lower rates ahead. Yet there is still ample market uncertainty and risk that highlights the need for rigorous best practices related to collateral value updates.

On the positive side, there is a view that property values have stabilized across most sectors. Public REITs have been leading that rebound. According to the FTSE Nareit All Equity REIT Index, prices are up 10% year-to-date through mid-October.

“At any point in time, there's a fair amount of challenges on specific valuations, but as a whole, we appear to be getting to a better place given some of the forward-looking guidance that we've been hearing from the Fed on interest rate reductions,” says Tim Kuhn, Director in Valuation Advisory at Altus Group. Office is still very much a troubled asset class unless it’s backed by strong occupancy and exceptional weighted average lease term (WALT). “Those examples are far and few between, and most of the traditional office format is still a puzzle for lenders to figure out,” adds Kuhn.

Higher debt costs have been an added headwind for borrowers. The focus now and in the past two years has been getting a sense from borrowers themselves on how properties are performing and the scope of any underlying challenges they’re dealing with at the asset level. For lenders, how do those conditions impact money that has been lent, and what does that mean for potential proceeds that lenders have yet to get back?

Collateral valuations in a falling rate environment

The recent period of market volatility, rapidly rising interest rates, and declining asset values highlighted the need for greater scrutiny and risk management. Collateral appraisals are perhaps less of a pain point in a market where the expectation is that values will be rising. What’s the go-forward strategy related to collateral appraisals in an environment where rates are now falling?

Collateral appraisals at origination are part of the standard checklist that debt funds and other lenders must complete in order to size the debt and make sure that they're comfortable with the Loan-to-Value ratio (LTV). In addition, there is still a need for ongoing collateral appraisals for some vintage loans that have been in a portfolio for two-plus years or longer and may be struggling with issues. Debt funds and CRE lenders need to stay on top of legacy loans that may be facing issues in what remains a challenging market for refinancing maturing debt. An estimated $950 billion of CRE loans are expected to mature in 2024, according to S&P Global. Due in part to loan extensions, maturities are expected to remain high for the next five years, peaking at $1.26 trillion in 2027.

Most of this debt originated when interest rates were close to 0%, and many of those loans are already working through loan modifications, extensions, and paydowns.

Legacy debt requires greater visibility

Lenders that anticipated stress hitting their portfolio are seeing the realities of that unfold. Office in particular still has a long road ahead in terms of reaching a firm bottom on values, as well as managing through delinquencies and non-performing loans. “This has been impacting portfolios for some time now and there is still room to go depending on vintage of particular loans and asset class,” says Andrew Pabon, Director in Valuation Advisory at Altus Group.

Challenges surrounding debt maturities means that debt funds and other lenders providing CRE financing must gain visibility into the factors impacting the value of the real estate collateral underlying their book of loans. Are the steps you’re taking to evaluate your risks consistent with industry best practices? Are you able to assure investors and shareholders that you have fully evaluated the risks and are taking the appropriate action where necessary?

Such questions remain pressing in a market still working through maturities that have experienced a significant reset in basis. Recent loan delinquencies continue to demonstrate the seriousness of persistent market challenges.

For example, the $242 million, 521 Fifth Avenue loan was sent to special servicing in June due to maturity default. According to Trepp, the lender is reportedly planning to dual-track foreclosure proceedings while continuing discussions with the borrower on an extension. Trepp also reported that the $300 million loan backing Santa Monica Place has moved back to 30 days delinquent according to August servicer data. Macerich Co. is the owner of the 523,139 square foot shopping mall in Santa Monica, California with the loan that is held by a CMBS trust.

As lenders work through loan extensions and modifications, they need updated collateral appraisals to gain insight into current valuations. As a means for taking appropriate action and providing transparency to investors and shareholders, it is especially imperative for lenders with commercial real estate balance sheet risk to conduct timely valuations of collateral to understand structural risks.

• Do you fully understand the risks in your portfolio?

• Do you have a current perspective on its collateral values?

• What might the situation look like if covenant testing is missed for loans that are nearing maturity, or if you can't refinance?

Refining assumptions as pricing gap narrows

The rate easing cycle is expected to help narrow the bid-ask gap. Broadly speaking, there is already evidence that the market is moving closer to that equilibrium point where buyers and sellers are moving closer together. “We’re seeing clients that are taking their foot off the brake and pushing a little bit on the gas. There are more deals being reviewed and more transaction activity happening on both the lending side and the equity side, with the expectation that activity is going to ramp up more in 2025,” says Pabon. The increase in transaction activity will provide more clarity into market values and cap rates to inform collateral appraisals.

At the same time, there is a stratification in the market where there is opportunistic money on one side and those investors dealing with problem assets or collateral on the other. Both of those sides need to come together on value in order to get through some of the pain and get back to equilibrium.

As the bid-ask gap narrows, more transactions are occurring that are providing evidence on the prices at which assets will trade. Office has experienced the biggest declines in value and has now moved to the point where the “fire sale” prices have reset as the market value for owners, and sellers are starting to adjust their expectations. “That’s a good thing. We need these assets to move to the money that can execute strategy on them and get them into performing assets,” says Kuhn.

Best practices: From reactive to proactive

Obtaining updated collateral appraisals is an important component to best practices for internal reporting requirements and communicating with stakeholders. In the past, valuation policies related to collateral traditionally have been structured to be reactive rather than proactive. Most debt funds and CRE lenders valued collateral at the time of origination and rarely afterward. In some instances, valuations might have been updated as part of an extension or modification within the loan process, or if there was significant concern with performance or the business plan.

The recent period of market volatility, rapidly rising interest rates, and declining asset values highlighted the need for greater scrutiny and risk management. Given the likelihood of significant risk within real estate debt portfolios, commercial real estate lenders needed to assume a proactive stance. It became more critical to re-evaluate existing collateral valuation processes or develop a new process that addresses current circumstances and challenges.

Going through the process of getting updated collateral appraisals helps provide a realistic understanding of where things stand for lenders in regard to debt receivables in their portfolios. What do we think is a reasonable or feasible basis for collateral values? What proceeds do we actually get back on these loans? Those updated collateral appraisals help support decision-making as lenders start to think about next steps for specific assets, such as foreclosure, Real Estate Owned (REO), or what to expect if they were to take an asset to market for a sale.

Lessons learned

The rising rate environment drove greater demand to increase the frequency of updated collateral appraisals. Now it’s important to look at the need for updated collateral appraisals in this current environment from two perspectives. Those assets that face challenges and uncertainty will require close attention and updates to manage risk, and lenders and debt funds need to continue to watch where collateral valuation may shake out on a go-forward basis.

New originations that are getting closed now are heading into this more optimistic environment, with expectations that values will start to appreciate versus depreciate. In that case, although updated collateral appraisals always make good sense, the need for more frequent updates may not be as necessary. “As we've gone through this pain and instituted these practices over the last 12 to 24 months, hopefully, maintaining periodic updated collateral appraisals will remain as part of best practices because lenders see the value in it,” says Pabon.

Updated collateral appraisals are a common practice on the equity side. “Now it’s a matter of bringing these best practices over to the debt side to show that it makes sense to do updated collateral appraisals more frequently than just at origination or every three years,” says Pabon. The value is that lenders get that clarity over and over again, as opposed to waiting for that material event to prompt an update.

Those firms engaged in alternative lending and debt funding that survived the Great Financial Crisis (GFC) of 2008/09 protected their principal commitments. To accomplish this, they gained a full understanding of their collateral basis and wielded pre-emptive strategies to maintain commitments. Since that time, the CRE industry has had a massive inflow of new alternative lenders, many of which have never experienced a period of financial turbulence. Additionally, many have not developed robust practices for monitoring and valuing collateral, which is crucial during such periods.

Those groups that have been through the GFC recognized the need to move quickly to expand or modify their processes. “The groups that have been through more cycles see the benefit. They know that they're going to have more questions about these underperforming loans. They know that they're going to need to have third-party opinions or consultation to answer the many, many questions that they’re going to have from investors and from their leadership. So, they are quicker to respond to adjust their processes,” says Kuhn.

3 strategies that shape best practices

While robust periodic collateral valuations are a recent advancement in the lending community and best practices are ever-evolving, three strategies are key.

1. Immediate triage

Internal or external valuation teams should begin by identifying the most urgent risks in portfolios. This involves focusing, from a lender perspective, on both at-risk collateral as well as performing collateral that is potentially problematic in light of operational and capital market conditions.

Stress testing should include adjusting collateral cash flows on the downside and determining how that would impact loan covenants, the loan-to-value ratios and the ability to recover the original loan amount.

2. Annual review

Once immediate risks have been addressed, an annual review of a larger subset of the portfolio yields a deeper understanding of the impact of real estate volatility on collateral and can help to minimize potential risk of non-performing loans.

3. Best practices for valuation frequency and processes

Moving forward, there should be a determination of best practices for valuation frequency and processes. As with all valuations, these practices must facilitate transparency and accountability of procedures and comparability of results. This requires determination of the purpose, scope and valuation methods utilized when integrating and scaling, communicating, and finally, reviewing the process. To ensure an actionable approach, the valuation director, a representative of the asset management team, and the Chief Risk Officer or Chief Operating Officer should be involved in developing best practices for the portfolio or fund.

Leveraging third-party expertise for collateral valuations

Given that resourcing can be challenging for some lenders, partnering with an external valuation management provider can support your team with experience and expertise. An objective provider can offer recommendations regarding timing and approaches based on what is most appropriate for your fund as well as industry best practices. Complete or partial outsourcing of valuation management can range from assistance with process recommendations, to the completion of appraisal reports, or the third-party review of valuations.

Additionally, this outsourcing provider should be willing to consult with a range of internal stakeholders to understand key concerns and challenges. To support accurate collateral valuations, they should also be able to offer insights related to assumptions and overall conclusions for a range of property types and markets. In today's climate especially, it's important to align with professionals who have a thorough understanding of valuation trends, industry best practices, benchmarking, and their impact and value.

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