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.