In this ongoing article series, the attorneys at Goulston & Storrs will keep you up to date on the current and emerging issues related to workouts and the Commercial Real Estate market.
In cities across the country, “for lease” signs dot the downtown landscape. The pandemic aftermath – with employers maintaining hybrid or fully remote work policies and interest rates remaining high – has turned formerly bustling downtowns into veritable ghost towns.
The result: commercial real estate sales in major metropolises have slowed considerably and, in many cases, have presented some jaw-dropping price reductions. New York is on pace to see less than a third of its historical 10-year average in commercial real estate investment sales this year. In Boston, a pair of office buildings at 33-41 West Street recently sold for just over $4 million, a quarter of their $16 million price seven years ago. And in DC, owners are seeing valuations of certain downtown office properties that reflect a drop of 50% to 75% from the most recent sales.
This downshift is prompting real estate owners and their lenders to have tough conversations if the outstanding balance of a maturing loan is greater than the current value of the property. There are numerous vehicles by which these distressed assets might change hands if refinancing or restructuring isn’t a viable option. This includes foreclosures, deed-in-lieu transfers, and short sales, which are becoming increasingly popular in the current economy. This is what you need to know about short sales.
Advantages to Short Sales for Both Sides
Short sales can be a good solution for borrowers looking for an exit strategy. With today’s high interest rates, reasonable refinancing options are limited and costly. And as properties experience steep drops in value, short sales can be a favorable alternative to foreclosure or a deed in lieu. For example, if a lender agrees to allow a borrower to run the sale process, there even may be an opportunity for the borrower to earn a small percentage of the proceeds over a threshold expected sales price (which the lender and borrower typically agree upon prior to marketing the property). Additionally, short sales can present an efficient solution for directly transferring a property to the new buyer and terminating any lingering obligations that might exist after a deed-in-lieu transfer to the lender.
For lenders, a short sale is attractive because they avoid owning and managing a property that has lost a substantial amount of its value since origination of the loan. Without having to adequately maintain (and, in some cases, lease up) a property during a period of possession, lenders avoid added expenses and obligations. Once the borrower transfers its interest to a new owner, the lender can realize the loss immediately and move on. Additionally, a short sale can avoid the double recordation and transfer taxes attendant to a lender taking title to the property by foreclosure or deed in lieu and then selling it to a third-party purchaser. Finally, lenders can eliminate further risks associated with foreclosures should a borrower stop maintaining a property prior to transferring it to the lender. Failure to maintain properties often leads to further devaluation of a property, making it harder to sell after repossessing.
Consequences for Borrowers
One of the biggest risks to pursuing a short sale is the potential for a long marketing and closing period due to uncertainty in the current market both in terms of valuation of distressed assets and the higher overall costs of capital and construction facing potential buyers. Short sellers are likely to find fewer bidders than in previous years. They may also encounter potential buyers that elect not to proceed beyond their diligence period because their plans fail to pencil out once they diligence the property, whether due to increased financing costs, unexpected repairs or other hurdles to redevelopment. When electing to pursue a short sale, borrowers and lenders are looking to move on from the property as quickly as possible. Failing to execute a sale after taking time to negotiate a purchase agreement and allowing the buyer to diligence the property can be very disheartening for all parties involved. Another potential risk of a short sale to the borrower is the potential exposure to tax liability if the amount of debt is greater than the taxpayer’s basis in the property or if there is forgiveness of recourse debt.
Overall Forecast for Short Sales
The uptick in short sales likely won’t subside any time soon. Trends point to continued high interest rates while occupancy rates and demand for certain classes of downtown office space decreases, resulting in difficult conversations between lenders and borrowers as loans approach maturity. This squarely places the downtown office market in jeopardy, potentially prompting deeper losses for property owners and borrowers.
It’s likely that short sales will become more attractive over time. Offering a smoother, more efficient alternative to foreclosures and deeds-in-lieu, short sales allow both borrowers and lenders a pathway to move on from a distressed property.
Should a short sales become necessary, it is always prudent to get the full picture of the advantages and consequences to disposing of a specific asset this way. Working with a team of knowledgeable advisors helps borrowers and lenders make informed decisions.
The authors are attorneys at Goulston & Storrs where they are members of the firm’s Commercial Real Estate Workouts Group, which is a multi-disciplinary team of restructuring, real estate, litigation, and tax attorneys who guide clients through the complexities of commercial real estate loan workouts. In this ongoing article series, Goulston & Storrs will keep you up to date on the current and emerging issues related to workouts and the CRE market. For more information, email the team at [email protected].