As the private real estate industry continues to be squeezed by the inflationary environment and interest rate hikes, Japan’s Aozora Bank expects there will be more real estate borrowers handing the keys back to lenders.
James Haines, general manager, head of global real estate structured debt at Aozora Bank, told PERE that the bank prefers to work with the borrowers than to take possession of the underlying real estate assets.
“Generally, banks don’t want to own real estate, so we try to pick those clients ahead of time who we believe will reasonably support assets. You want to support your clients, but there are just cases where there’s just nothing that can be done except taking possession of the asset and selling it. We haven’t had a lot of that, but we can see that there’s definitely more coming.”
Of the approximately $4.5 trillion of outstanding US commercial real estate debt, nearly a third – up to $1.46 trillion – is coming due before year-end 2025, according to a Morgan Stanley report published in April.
However, Haines noted the price of an interest rate cap has become one of the biggest obstacles for real estate borrowers to negotiate a loan extension with the banks.
“Floating rate real estate loans are generally hedged, meaning they have an interest rate protection agreement in place, whether it is buying a cap or put in place a swap. You don’t usually do a swap for a shorter-term loan, so caps are more common in those cases,” he explained. “You really need that one extension condition to bring people back to the table to sit down and talk. But those caps became very expensive in late 2022, and while prices have declined somewhat, they continue to be a major challenge for borrowers right now.”
Rate caps become more expensive as rates rise because cap providers account for rate volatility and the yield curve in the contracted period. In this case, the base rate in the US increased significantly from 0.25 percent in December 2021 to 5 percent in June 2023.
In a market where liquidity continues to be strained, Haines noted both borrowers and lenders are cautious about “throwing good money after bad.”
“We’re starting to see sponsors picking and choosing which assets they save and which assets they let go of. Even the biggest guys in the market, they’ll continue to have to make those tough choices. They’re not going to be able to save everything,” he said.
On the other hand, he noted lenders also have to be more cautious and to think about to what degree they want an asset when the borrowers are having repayment troubles.
For this reason, the Japanese bank has become more selective when evaluating borrowers and underlying assets for new originations. PERE understands that the bank’s pre-covid new origination volume was around $1 billion per year, but new origination activity has slowed down significantly because loans are not turning over as quickly. Aozora had an overseas commercial real estate loan balance of $2.8 billion as of March 2023.
The bank has also been more careful about underwriting new loans backed by office assets. “While office will continue to be part of the mix going forward, we have been focused on decreasing our portfolio weighting of office since last year,” Haines noted. Since launching its overseas structured debt business 10 years ago, the bank’s biggest real estate loan exposure has been to the US office sector, due to loan availability in the syndication market.
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