On 22 March, Tom Barrack, chairman and chief executive of property investor and lender Colony Capital and one of private equity real estate’s highest-profile executives, wrote a white paper warning of the possible collapse of the US commercial mortgage market.
Liquidity was the issue. With businesses cut off from cashflow as a result of the lockdowns, he wrote, many would be unable to meet loan repayments. In a May filing, it emerged that Colony itself had defaulted on $3.2 billion of loans held against hotel and healthcare properties.
Data on the US commercial mortgage-backed securities market, a good indicator of the state of US real estate debt more broadly, have also caused concern. In May, Fitch Ratings reported that the CMBS delinquency rate had ticked up slightly to 1.32 percent in April following 12 consecutive months of decline. In early April, Fitch made the morbid prediction that the rate could peak at around 8.75 percent by the end of the third quarter. That would not be far from the July 2011 peak of 9.01 percent.
Another rating agency, S&P Global, said in a 12 May note that the proportion of loans overdue and in so-called ‘grace periods’ had increased to 7.6 percent in April, up from 2.1 percent, thereby indicating a looming concern for the upcoming months.
S&P director Natalka Chevance believes the “uncertainty of duration” of the pandemic is the ultimate problem facing US CMBS. “Even compared to 9/11 or the ’08 crisis, this is unprecedented,” she says.
In his white paper, Barrack also highlighted a pressure point in US real estate debt. Many non-bank lenders are funded by credit lines from banks, subject to mark-to-market pricing assessments. Widespread margin calls by the banks, said Barrack, could lead to a credit crunch.
Kevin MacKenzie, executive managing director at property services firm JLL Capital Markets, tells PDI‘s sister title Real Estate Capital that debt funds and mortgage real estate investment trusts were subject to margin calls as the crisis hit in March. He says that forced sales caused AAA-rated CMBS spreads in the secondaries market to move out to more than 350 basis points by mid-March.
Some calm was restored on 9 April when the Federal Reserve shored up liquidity by adding AAA-rated CMBS as eligible collateral for its emergency programme of lending to buyers of asset-backed securities – a second iteration of the Term Asset-Backed Securities Loan Facility programme originally launched in 2008.
MacKenzie argues that US lenders are taking a flexible approach with many sponsors. “On the defensive side, lenders are monitoring portfolios, fielding borrower requests, [and] generally being thoughtful about allowing tenant rent relief and forbearance for 90 days where a real need or cause is exhibited,” he says.
At least 27 banks across the US have announced their commitment to providing mortgage relief or forbearance during this time – a largely unprecedented move. “They are holding through this pandemic and are not likely to act until there is more clarity in the US about re-opening,” says MacKenzie.
Nishant Bakaya, chief investment officer of Chicago-based property investment manager CA Ventures, agrees that the fast reaction from the top was crucial in preventing defaults from spiralling any further. “The Fed moved quickly to inject liquidity, and that stabilisation has been an incredible help to markets,” he says.
He contends that lenders remember what happened during the last cycle and that foreclosing during a downturn like this “is not a smart thing to do, as most of the issues are due to short-term liquidity”. “This is a forced downturn, driven by a unique global shutdown and not due to poor fundamental performance,” he adds. “It is not driven by malfeasance or systemic overleveraging, and it is going to pass.”
However, expectations of a rising CMBS delinquency rate suggest serious issues lie ahead for the US real estate debt market. MacKenzie adds that the TALF programme covers only the highest-rated CMBS, leaving legacy BBB paper trading at spreads of 800-1,000bps over the corresponding treasury.
He argues that higher-risk CMBS and debt fund loans are a much smaller part of the real estate lending market than they were in the run-up to the 2007-08 financial crisis. Federal agencies, insurance companies and banks made up 75 percent of the real estate debt market in 2019, compared with 40 percent in 2007. He believes this will help the market to remain steady.
He also believes banks’ exposure to real estate is more robust than it was in 2008. Through the credit lines and repurchase agreements highlighted by Barrack, banks typically hold around 70 cents on the dollar of high-yielding debt, says MacKenzie. “If there are challenges with these loans, the lower leverage position, along with the strength of banks’ balance sheets, will allow time for banks to hold, evaluate and monitor – which could keep a flood of unwanted paper off the streets while navigating any dip in real estate fundamentals.”
Even if lenders are well capitalised, they are cautious about providing new debt at this point. At the beginning of 2020, many market participants expected 8-10 percent growth in CMBS issuance this year. As a result of covid-19, it could easily drop by 30-40 percent year-on-year, according to S&P.
“Lending activity continues to shift day-by-day, but there is ample liquidity among the majority of lenders for the right transactions,” MacKenzie says. “There is plenty of liquidity across the spectrum to play offence, but the focus is mainly on distress and ‘have to’ trades as of the end of April.”
He says that, between mid-March and the end of April, JLL Capital Markets itself closed nearly $5 billion of real estate lending transactions in the US.
Other economic factors will have a ripple effect on real estate. S&P’s Chevance points to rising unemployment, which will not only affect mortgage and rent payments, but also the purchasing power of US consumers. Depending on how long the economic shutdown will be in place, recovery could become more difficult.
Despite the increased risk, CA Ventures’ Bakaya believes that “the next 24-36 months could be some of the best investment months the real estate industry has seen in a long time”. He has also seen no indication that investors’ allocation to real estate will change drastically because of the crisis.
However, this period may lead to fundamental changes in the real estate market. Bakaya notes that income has held up well in alternative assets such as student housing and senior living, as well as in industrial – and more so than in the more standard sectors of offices and retail.
This, Bakaya believes, will shape future allocations to real estate across the market: “I expect to see capital flows continue to migrate away from retail and office to multifamily, industrial and alternatives such as student and senior housing, now that the long-term secular demand drivers of the different asset classes have better visibility.”