Selective Defaults Could Become a Headache for CRE

Commercial real estate professionals understandably spend considerable time looking at CRE financial trends, regulations, and potential risks. But sometimes important information comes in more general forms, like inflation and resulting Federal Reserve interest rate hikes. The general eventually becomes the specific.

A new S&P Global Ratings report on credit trends is one of those times when something of larger scope has implications for the CRE industry. The firm sees a rather startling increase in selective defaults — from 25% in 2008 to more than 66% in 2022, though so far, year to date, in 2023 down to just under 50% — in which a company defaults on specific obligations but not others.

“The percent of selective defaults in North America was just 21% in 2008 compared with 65% of defaults in 2022,” S&P wrote.

If your business is not the one facing that selective default, it may seem like you’ve dodged an unpleasant situation. But as S&P explains, this may not be a sustainable position, meaning that may be an impact to others owned money, including real estate property owners.

“Out of court, often lender-led restructurings do not necessarily result in permanent solutions,” S&P notes, “because more than one-third of issuers that initially selectively defaulted have subsequently re-defaulted. In addition, selective defaults are not necessarily sustainable, with issuers defaulting again, on average, only 1.7 years following the previous selective default.”

One reason for the growth, says S&P, is attempts at “asset value preservation” and the move for lenders and issuers to “restructure out of bankruptcy court.”

“Much of the increase in selective default is to some extent linked to the increased growth of sponsor-owned companies in the last decade,” they wrote. “During this period, the dynamics of power shifted to the sponsors as some were able to extract better deal terms and build in flexibilities into their credit agreements. The flexibility and weaker covenants provided room for sponsors to effect transactions to tap or preserve liquidity when their portfolio companies underwent stress. These out of court restructurings helped companies avoid a bankruptcy and keep asset value and maintain company ownership control for PE [private equity] firms.”

However, a restructuring out of court “may not always address the secular or operational issues for the entities.” The report goes on to say, “The data highlights that if an issuer defaulted through a general default (largely missed payment or bankruptcy), there is a 4.8% likelihood the same issuer will default again within a 48-month period. However, if an issuer defaulted because of a selective default, there is a 34.9% likelihood the issuer will default again during that same period.”

So, while some firms that try a selective default can “regain their footing, staving off a more comprehensive (and costly) bankruptcy restructuring” will succeed. So, if faced with a selective default on the part of a tenant, be wary about seeing such a procedure as a way to a more stable future.