Real Estate

Dwight Cass

CRE Finance: From Bad to … Slightly Less Bad

Commercial real estate market participants had some reasons for optimism in the third quarter. Banks continued to avoid large realized losses on CRE lending. Lower infection rates in some large cities allowed them to ease lockdown measures, benefitting the retail, office and lodging sectors. But despite these promising signs, and irrespective of the near-term course of the pandemic, Covid-19’s long-term effects on the CRE market are shaping up to be profound.

CRE property values continue to fall, although data from Moody’s Analytics shows a decrease in the pace of declines in the third quarter. Even so, office sector properties fared badly, with appraised values of troubled assets falling 77% in the second quarter and 60% in the third.

Although banks do not hold much CMBS, their direct loans are worrying. According to a recent Financial Times analysis of the 10 biggest bank CRE lenders, the size of their problem loan holdings had increased 144% since the beginning of the crisis, to $26 billion. These loans are now equivalent to debt with a rating deep in junk territory – CCC or lower.

Other types of lenders are no better off. The rating agency Fitch says that life insurers will see 50% greater losses on their mortgage loans than they did during the Great Financial Crisis. Fitch also expects U.S. CMBS delinquencies to be near their previous peaks of 8.25-8.75% in the fourth quarter of this year.

Luckily, there are signs of life returning to some sectors, even office. Kastle Systems, which provides employee monitoring equipment for 41,000 businesses in 47 states, says its ten-city average occupancy index rose to 25.8% at the end of September, up from its April nadir in the mid-teens. Some cities have done significantly better, such as Dallas and Los Angeles. Even New York, the U.S. epicenter of the pandemic, has seen some improvement, although occupancy still languishes at 15.6%, according to Kastle data. San Francisco is at the bottom of the list, with only 14.5% occupancy.

While financing will eventually struggle back, analysts say Corona-19 dislocations will fundamentally change the CRE landscape. In a recent report, Fitch’s structured finance team wrote, “The effects of the pandemic will accelerate secular trends that were already underway prior to the crisis. The pandemic has also introduced new challenges to social and business transactions that will affect retail, office, lodging, industrial and multifamily housing to varying degrees.”

A forecast by Cushman & Wakefield supports this, as it applies to the future of the office sector. According to the firm’s model, the U.S. office market will shed 145 million square feet of space in the next two years. The firm expects office demand to decrease by 30% more than it did during the Great Financial Crisis. Those changes will not be reversed easily. While signs of progress in fighting the pandemic might be encouraging, CRE market participants should temper their optimism with the understanding that this business is undergoing fundamental change, the full extent of which is only now becoming apparent.

Dwight Cass

Price Discovery a Key Hurdle to Renewed CRE Lending

Commercial real estate companies are facing unprecedented challenges during the Covid-19 pandemic as they attempt to raise financing for new and ongoing projects. Tighter bank lending standards and widespread problems in the commercial mortgage-backed securities market are immediate issues. But CRE debt markets will not stage a significant comeback until assets start changing hands so that price discovery recovers, giving lenders the benchmarks they need to estimate LTVs and risk.

The lack of useful pricing data is reflected in the Green Street Commercial Property Price Index, which showed CRE asset price declines of between 5 and 25 percent in March and April, but which did not move notably between then and August because of the lack of transactions.

“The transaction market is quiet these days—and properties that are trading are ones relatively unaffected by the pandemic—so it’s tough to say with certainty how much pricing of some property types has changed,” said Peter Rothemund, Managing Director at Green Street Advisors. “But it’s pretty clear that the range of outcomes is going to be wide. Record-low interest rates mean properties with a stable top-line outlook will hold up well. Those with some risk, say multitenant office, probably see something like a 10% hit on average. And those with a lot of hair, like lodging and some retail, lose even more.”

Office projects in urban areas are expected to be particularly hard hit. Data from Kastle Systems, which manages employee tracking systems for over 41,000 companies in 47 states, shows that New York City office occupancy is now only 11.7 percent, and Kastle’s 10-city average languishes at 23.3 percent.

The hospitality and retail sectors are equally troubled. Fifty-four percent of CMBS loans transferred to special servicing entities due to delinquencies since March are backed by hotels, according to ratings firm Fitch. Another 32 percent are backed by retail properties, including malls.

Banks have responded to the CRE meltdown by becoming significantly more conservative. In the second quarter, two-thirds of banks surveyed by the Federal Reserve tightened standards for CRE loans. The remainder left them unchanged. Over a third made their lending standards tighter than at any time in the last 15 years.

The CMBS market, meanwhile, is being roiled by near-defaults, avoiding outright ones through special servicing, extend-to-pretend refinancings (also a favorite tool of banks for the CRE mortgage assets they retain), and forbearance measures. According to Fitch, $35.5 billion of U.S. CMBS was pushed into special servicing in the second quarter, up from $4.6 billion in the first. That’s up from a total of $9.1 billion at year-end 2019. The first half total represents 7 percent of the entire CMBS market.

Even with these discouraging signs, pressure is growing to get the CRE financing markets rolling again. As Ethan Penner of Mosaic Real Estate Partners recently told the Financial Times Odd Lots podcast, asset managers are piling up uninvested cash that they sorely want to put to work in order to be able to charge fees. Penner, credited with inventing the CMBS market in the early 1990s, cautioned that government policies like forbearance and the Fed’s ZIRP subsidy for refinancings reduce the pressure on owners of troubled assets to sell. This deprives the market of the data points it needs to establish prices on comparable assets. Without those, banks cannot feel confident generating LTVs and risk assessments, and asset managers will continue to fear buying assets for more than they are worth.