Insight

Under Pressure

Capital markets commercial real estate is under pressure, and creativity is needed to make deals in 2023.

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AR

Antonios Roustopoulos and Sara T. Wagner

February 20, 2023 12:00 AM

In an increasingly complex geopolitical and economic climate, commercial real estate professionals will need to bring creativity and flexibility to transactions to adapt to ever-shifting market conditions. The headlines are pessimistic: the war in Ukraine is entering its second year, the United States has hit the debt ceiling and Goldman Sachs has laid off 3,000 staff members. These developments have occurred against a backdrop of continued concerns over consumer inflation and interest rates, painting an overall gloomy outlook for commercial real estate (CRE) dealmaking in 2023. The uncertainty of today's climate, however, can be turned into tomorrow's opportunities. So while there is ample room for glumness in this market, real estate dealmaking opportunists will adapt and use creativity to execute transactions in 2023. But what will this adaptability and creativity look like?

Office Conversions

One area where we have already seen this type of adaptability is the office conversion trend which has been especially popular for older office inventory, especially in the coastal and Mid-Atlantic CRE markets. The authors of this article practice commercial real estate law in Wilmington, Delaware, just south of Philadelphia, and have assisted clients with numerous office conversions. Office conversions to residential units are seen as promising avenues to potentially combat our nation's housing crisis. Some public policy analysts have posited that office conversions to multifamily use could help address the housing crisis. Due to the complexity of the legal issues affecting the conversion of an office building to multifamily use, government intervention may be necessary in some markets to create a legal framework that incentivizes and permits conversions. Recognizing this, New York City recently commissioned an Office Adaptive Reuse Study, which identified eleven recommendations to modify state laws and city zoning requirements to help create the legal framework for office conversions. One of the most significant legal considerations of an office conversion is the applicability of land use and zoning rules and regulations, which could include things such as rezonings, variances and historic review approvals, among others.

For office buildings that are not completely vacant, the owner will have existing leases to contend with. Terminating existing leases or relocating existing tenants can be complex, especially if existing leases do not provide landlords with termination or relocation rights. In considering a conversion that will displace tenants, care must be taken to contemplate the existing contractual issues presented by current office leases.

Pandemic work-from-home propensities have had a profound effect on office buildings, increasing vacancy rates and creating difficult valuation and financing conundrums. Work-from-home trends appear to be shifting in some industries. Twitter, for example, made headlines recently when Elon Musk ordered all staff back to the office. As work-from-work propensities mount, owners of office buildings will be under pressure to offer amenities and greater quality to entice tenants back to the office. Older office stock will have trouble competing with class A spaces that check all the boxes in terms of location, quality and sustainability, which will be better positioned to lure work-from-work companies back to the office as tenants. However, the owners of office inventory that cannot meet changing tenant demands for amenities and quality will need to make decisions about how to operate these assets in a post-pandemic world. Conversion may be a solution for some of these assets. While office conversions to residential units are popular, conversions to other uses, such as hospitality, mixed residential/commercial uses and life science spaces, especially wet labs, are also part of this strategy.

One of the most significant legal considerations of an office conversion is the applicability of land use and zoning rules and regulations."

If conversions are not feasible, other options for owners of vacant or underperforming commercial office buildings range from selling at a discount, reducing rents or handing the keys back to the bank, all of which have their own business and legal issues to contend with. When sponsors weigh the options, office conversions can be appealing but present many factors to consider, ranging from the cost of conversion to the type of reuse. Capital considerations are significant, as are structural issues (i.e., floor plate size, window lines and heights), and legal issues always require thoughtful analysis.

Creative Financing Structures

Another potential area for CRE creativity may be through the use of seller-provided financing. Increasing financing costs, limited debt availability and uncertain valuations continue to plague the CRE sector as we enter 2023. As debt continues to be harder to come by, one way to adapt to the current conditions may be through creative structuring. In the third quarter of 2022, Moody’s Analytics reported that the cost of debt on multifamily and industrial properties has risen at a pace that has resulted in financing costs exceeding earnings from rents. A property suffering from negative leverage will be difficult to sell as the cost of debt exceeds the projected rate of return. While not a new structure, seller-provided financing may solve some negative leverage issues and confront the effects of rising financing costs by bridging them with creative seller financing.

Seller-provided financing is typically structured by the seller making a loan of some portion of the purchase price to the buyer. The loan typically provides the buyer with part of the funds needed to finance the purchase price of the real estate asset being sold. This form of financing is also frequently referred to by lawyers as "purchase money financing." When used in commercial real estate transactions, flexibility abounds. While it is not unusual for the seller-provided loan to be secured by a mortgage or deed-of-trust on the real estate being sold (i.e., a purchase money mortgage), it is not required. Seller financing can be secured through a pledge of equity in the buyer entity. It can even be an unsecured obligation guaranteed by a credit-worthy entity or individual.

There are risks and considerations with this type of structure, including complying with any applicable legal requirements such as lending laws and state licensing. In commercial real estate, buyers typically acquire assets with secured debt. If seller financing is used to bridge part of the buyer's capital for closing, the seller will need to be subordinated to the senior lender. And it is not uncommon for senior secured lenders to prohibit secured liens on their collateral. When purchase money financing is permitted in the capital stack, an intercreditor and subordination agreement is typical. For some deals, utilizing seller-provided financing could create the capital stack needed to address current capital market financing hurdles and is another tool in the CRE professional's toolkit for adapting to current economic conditions.

Certainly, it is challenging to transact CRE deals in today's economic climate, but creativity will help position market participants with new opportunities. As the market adjusts to the current economic and geopolitical trends, market players will become more comfortable that the capital markets are predictable and reliable, which in turn will reenergize the overall real estate market. Meanwhile, those investors who adapt to changing circumstances will be able to turn today's challenges into tomorrow's opportunities.

The views expressed in this article are those of the authors and not necessarily those of Richards, Layton & Finger or its clients.

Sara T. Wagner is chair of the Real Estate Services Group at Richards, Layton & Finger, P.A. and focuses her practice on complex transactions involving the finance, acquisition, sale, lease and development of commercial real estate properties. With “technical competence” and an “impeccable skill set,” she represents major real estate developers, financial institutions, significant holders of commercial real estate and institutional clients in all types of commercial real estate transactions.

Tony Roustopoulos is an associate at Richards, Layton & Finger, P.A. and focuses his practice on matters related to commercial real estate, which range from simple real estate transactions and financings to complex business matters related to real and personal property. He represents developers, lending institutions, borrowers, landlords, tenants and other holders of commercial property, whether institutional or family owned, in a broad range of real estate and business matters.

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