7 minute read 7 Dec 2020
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How lenders may respond to a different cycle, similar stress

Authors
Meredith Ager

Managing Director, Strategy and Transactions, Financial Services and Real Estate, Ernst & Young LLP

Capital markets and commercial real estate executive. Innovation and team success drive me. Passionate cook and mom to one daughter.

Danielle Testa

Senior Manager, Strategy and Transactions, Financial Services and Real Estate, Ernst & Young LLP

Capital markets and commercial real estate executive. Mom to one son. Loves DIY projects and baking.

7 minute read 7 Dec 2020

Lenders can be proactive to avoid potential increased risk and losses in their portfolios.

In brief

  • History shows that commercial real estate defaults typically peak 8 to 12 months after the beginning of a financial crisis.
  • Although COVID-19 has plagued the US for months, private market commercial real estate values have remained mostly stagnant with a few notable exceptions. 
  • When values begin to decline borrowers may find it difficult to refinance, potentially leading to a wave of foreclosures.

While the US has been dealing with the effects of COVID-19 for over six months, commercial real estate (CRE), as an industry, has only begun to feel the impact. The federal government quickly enacted stimulus programs such as the Economic Impact Payment of $1,200 and the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which helped individuals pay rent and purchase retail items through increased unemployment benefits, as well as allowed CRE borrowers to continue to meet debt service obligations through the Paycheck Protection Program. These programs have since expired with little appetite in Washington for additional stimulus. Despite this, and the ambiguity around the length of the pandemic and its lasting effects, private market real estate has not yet realized significant declines in property values when compared with public real estate investment trusts (REITs).

The public REIT sector is reporting October 2020 year-to-date return declines of 31% for office, 38% for retail and 45% for lodging.1 This is in stark contrast to the National Council of Real Estate Investment Fiduciaries’ quarterly returns for properties of +0.31%, -0.52% and -4.17%, respectively.2 Another point of reference, Green Street’s 6 October 2020 Commercial Property Price Index, notes office, strip retail, mall and lodging property values have declined 9%, 15%, 20% and 25%, respectively vs. pre-COVID-19 levels.3 What could explain the glaring difference between the views of the public and private markets?

Typically, private markets have lagged the public markets. Property valuations, which have been mostly unaffected (aside from lodging and retail), will likely begin to show sharp declines due to deteriorating cash flows, resulting in higher loan to value ratios (LTVs), which increases the risk of maturity defaults. Property sales volume has also decreased significantly, further jeopardizing the ability to repay loans at maturity. 

COVID-19 has shifted traditional thinking; we do not need to be physically present in a location to accomplish a task. Remote work, online shopping and virtual meetings have become the norm; as these trends continue post-COVID-19, the way we use real estate and thus our demand for certain types of properties will likely change in the long term, further impacting values. Continued cash flow disruption resulting from moratoriums and the onset of colder weather may hamper the ability to conduct business outside (e.g., New York City restaurants) and can lead to more missed payments as well as breaches of loan covenants.

The lack of widespread uniformity in the adjustment of property values, coupled with expiring stimulus programs that artificially and temporarily inflated cash flows, has allowed LTVs to remain relatively stagnant despite a growing threat to the health of property level cash flows.  

Using the past as a preview for our future

Prior to the last financial crisis, commercial mortgage-backed securities (CMBS) delinquencies totaled approximately 1.00% as of Q4 2008. As a result of the crisis, delinquencies rose to an all-time high of 10.34% in July 2012,4 four years after the crisis began, resulting in a wave of foreclosures. This likely gives credence to the argument that CRE is a lagging indicator to the general economy and why we are not yet seeing the effects of the pandemic in the private real estate market with valuation declines. 

Delinquencies did not stabilize until years later. However, the detrimental effect on CMBS lending persisted; as of 2019, CMBS accounted for approximately 14% of the lending market,5 down from its peak in 2007 when it accounted for over half. Banks fared better, with CRE delinquencies reaching a high of 8.75% in Q1 2010 and decreasing to 4.00% in 2012 when CMBS delinquencies were at their peak.6 However, at the time banks comprised only a quarter of the total CRE mortgage market whereas that percentage now stands at nearly 39%.7

Today, the CMBS market is already showing elevated delinquency levels. Loans operating under forbearance agreements, which Trepp estimates at $20 billion in the private-label CMBS market,8 and loans where reserves are used to pay debt service, are considered current and not included in the below figures, implying significantly understated delinquent figures.

The lodging and retail sectors became immediately distressed, due to mandatory closures, resulting in large and rapid increases in delinquencies, with highs observed in July 2020 of 23.79% and 16.10%, respectively, vs. 1.47% and 4.15% a year ago.9 The assumption that a borrower who is current or has become current through short-term intervention will remain current maybe a risky proposition. Forbearance agreements have expiration dates, and reserves are limited.

While delinquency rates have shown meager improvement over the past few months, the same cannot be said of special servicing rates. Rates for lodging have grown to 26% from 2% a year ago, while retail has increased to over 18% from 5% during the same time. 10 Even if loans are modified, which all loans due to volume cannot be, and brought current, the risk of maturity default likely remains. 

Considerations for lenders

Lenders are in the business of making loans to collect principal and interest payments; they are generally not owners and operators of real estate. However, if the potential for maturity defaults is not sufficiently addressed, that may indeed be what they will become. With property values declining and LTVs rising, borrowers may find it difficult to refinance, despite low interest rates. To secure new financing, borrowers may need to inject additional equity or find additional debt sources. However, borrowers may have a limited appetite and ability to pay out of pocket, especially for low cash flowing properties. While in the past an active property transaction market provided borrowers a way out, that is no longer the case. Lenders could be forced to foreclose on properties which are currently distressed, but more importantly, potentially obsolete due to altered use preferences.    

While banks are significantly better capitalized than they were during the last financial crisis, that may not be sufficient to weather the impending wave of foreclosures. During stressed times, exceptional portfolio management becomes vitally important. Reacting to distressed situations as they arise may not be optimal; the proactive identification of potential credit issues is likely critical. Banks may need to have a detailed understanding of their portfolios and the risks involved based on each property’s asset class, tenant base and geography. Property valuations may need to incorporate both the current and future effects of the pandemic. Detailed and real-time stress testing utilizing a multitude of assumptions and scenarios can become the industry standard.

COVID-19 caught the CMBS market off guard, resulting in numerous delinquencies to date. Banks may need to proactively plan and adapt now to avoid a similarly dire situation that could be followed by significant foreclosures. History shows that CRE defaults typically peak 8 to 12 months after the beginning of a financial crisis. Banks now represent a significantly larger percentage of outstanding CRE debt when compared with 2008. Proactive action today to recognize and adapt to the coming devaluation of CRE is important for the long-term health of any bank with real estate credit exposure.

Summary

The effects of COVID-19 have only begun to impact the commercial real estate industry. Lenders may need to plan and adapt now to avoid another dire situation that could be followed by significant foreclosures.

About this article

Authors
Meredith Ager

Managing Director, Strategy and Transactions, Financial Services and Real Estate, Ernst & Young LLP

Capital markets and commercial real estate executive. Innovation and team success drive me. Passionate cook and mom to one daughter.

Danielle Testa

Senior Manager, Strategy and Transactions, Financial Services and Real Estate, Ernst & Young LLP

Capital markets and commercial real estate executive. Mom to one son. Loves DIY projects and baking.