COVID-19 aftereffects continue to drag on Chicago commercial real estate

The Palmer House Hilton has reopened but foreclosure threatens. Gurnee Mills has received a respite from its lenders. The city opera is in purgatory.

After a scary 2020 for commercial real estate investors, the easing pandemic and recovering economy are taking away worst fears of a prolonged and painful slump – and a wave of foreclosures. But the market’s comeback in 2021 won’t save all long-haul real estate runners, the real estate that continues to be plagued by debt problems caused or exacerbated by COVID-19.

According to Trepp, a New York-based research and advisory firm, the Chicago area’s default rate on a major category of debt, commercial mortgage-backed securities, or CMBS, fell to 11.2 percent in May. That’s an improvement from the June 2020 peak of 14.0 percent, but it could take years for the rate to return to pre-COVID levels of 2-3 percent.

“I don’t think we’re out of the woods yet,” says Tom Fink, Senior Vice President and Managing Director at Trepp.

This statement applies to some of the largest properties that contribute to the region’s high default rate. The 1,635-room Palmer House, the second largest hotel in the city, reopened on June 17 after being closed for 15 months due to the pandemic. But its future remains a question as its owner, New York-based Thor Equities, seeks to settle two foreclosure lawsuits totaling more than $ 410 million.

Gurnee Mills, the area’s third largest mall, at approximately 1.9 million square feet, is in a better location. After the mall’s owner, Indianapolis-based Simon Property Group, defaulted on roughly $ 124 million in CMBS debt last year, it negotiated a forbearance agreement with a loan service provider in December to keep the property ahead of a possible Protect foreclosure.

In the West Loop, the owner of the Civic Opera building, Berkley Properties, headquartered in Nanuet, New York, is also trying to work out a forbearance agreement after stopping payments on approximately $ 164 million in CMBS debt, according to the public securities. Foreclosure is still possible.

The properties represent the three real estate sectors hardest hit by the pandemic – hotel, retail and office. Hotels suffered massive losses last year as business and leisure travel stalled and occupancy plummeted.

The CMBS failure rate for hotels in the Chicago area rose to 57.1 percent in October, largely due to the Palmer House troubles, and has fallen only slightly since then, to 55 percent in May, according to Trepp. Local hotels with delinquent CMBS debt include the W Chicago City Center, the Marriott Chicago River North, and the Hilton Orrington Evanston.

A recovery in tourist and business travel could lift many hotels out of harm’s way. The owners of some, like the Godfrey in River North, have already worked out loan modifications.

But lenders, after being patient with defaulting hotel owners during the pandemic, could also demand that borrowers do more to recapitalize their properties now that the market is improving, says attorney David Neff, an associate at Perkins Coie, who says specializes in hotel bankruptcies and restructurings. If a hotel owner calls on a lender to cancel some of their debt, the lender will require the borrower to put more equity into the property, he said.

“I think you will see lenders getting more aggressive,” said Neff, who is representing Wells Fargo lender in one of the foreclosure proceedings against Palmer House.

While he wouldn’t make any predictions about the fate of the Loop Hotel, Neff says the hotel’s reopening is a positive move. A Thor spokeswoman declines to speak about the suits, but says Thor is “looking forward to a brisk summer” at the hotel.

The recovering economy also bodes well for retail landlords, who were battered last year when retailers went bankrupt, closed stores, or stopped paying their rent. According to Trepp, the CMBS default rate for retail properties in the Chicago area rose to 29.6 percent in August.

An encouraging sign that retail defaults fell to 11.9 percent in May. Owners of some large properties, like Lombard’s Yorktown Center and North Riverside Park Mall, have negotiated loan changes and averted foreclosures. Instead of seizing a large mall and hiring another company to fix it, many loan service providers and lenders would rather negotiate a deal with a mall owner who has the expertise to flip it.

“People try to be rational about what they do because the alternative is to be tough and take a loss,” says Fink.

Still, the long-term outlook for retail is far from bright. For many home-bound consumers, the pandemic has only increased the convenience of online shopping, which has been taking a bite out of brick-and-mortar retail for years. Although shoppers are returning to stores, e-commerce will remain a growing threat to malls and other real estate, one reason to expect more hardship in the future.

The future is also uncertain for the office market. The CMBS default rate for local office properties has increased slightly, but is still relatively low at just 3.8 percent in May. The question is what happens in the coming years: will the demand for office space decrease if more professionals work from home in the post-pandemic period? Nobody knows at the moment, but Fink is preparing for higher failures.

“Office is going to be a slow burn,” he says.

Only one large downtown lot, a 487,000 square foot office building on 401 S. State St., was foreclosed last year, and the owner turned the building over to its lender. Rialto Capital, the loan service provider overseeing the Civic Opera Building, has not ruled out a foreclosure lawsuit against the 915,000-square-foot tower at 20 N. Wacker Drive, according to public records.

Although Berkley, the owner of the Civic Opera Building, has suspended mortgage payments, the property’s problems are mostly temporary, says Brian Whiting, president of Chicago-based Telos Group, the building’s leasing agent. Two collaborating tenants, Bond Collective and TechNexus, have struggled to make rental payments because people stopped coming to the office, but their business is coming back, Whiting says. He is confident that Berkley can reach an agreement with Rialto.

“There are friendly discussions between the lender and the landlord,” he says.

Investors looking for distressed properties could find some attractive opportunities in the future. The volume of distressed deals has been pretty low so far, but it’s still early days, says Jim Costello, senior vice president at Real Capital Analytics, a New York-based research and advisory firm.

But the deals will require different skills than those who were employed after the 2008-09 recession, he says. Many properties that got into trouble then suffered financial hardship: they simply carried too much debt that finance professionals cleaned up.

This time, more properties are suffering from operational difficulties – insufficient cash flow. It takes another person to solve these problems, says Costello.

“It’s not the financial sniper,” he says. “It’s the people who understand the cost of rebar.”