Commercial real estate loan defaults: Where do we go from here?

The commercial real estate world is preparing for two upcoming and potentially momentous events: the full rollout of the COVID-19 vaccine and the impact of credit deferrals on bank balance sheets.

On the one hand, the vaccine offers hope for a possible return to normalized cash flows. On the flip side, the upcoming earnings reports and regulatory filings at the end of the grace period should show the full impact of the pandemic.

So what is likely to happen to the CRE values ​​and, consequently, the CRE loan defaults?

It all depends on the type of asset. Retail, office, hospitality, and small business loans are at the forefront of potential problems. Industrial is doing pretty well. Apartment building steps on water.

The flow of red ink is likely to begin in the New Year. This is not only due to the pandemic itself, but also to longer-term mundane trends accelerated by COVID-induced changes in the economy.

Call to action

To deal with the growing volume of bad or subpar loans, bankers and lenders would be well advised to recall the painful lessons of the past.

Ten years ago, after the great recession, the best course of action was to sell troubled loans instead of waiting for a recovery. The same lesson is relevant for bankers and lenders today.

Those waiting for values ​​to return to pre-pandemic levels will be ducks. They are being swallowed up by institutions with 1) support from regulators and shareholders to buy weakened banks. 2) The advantage of a stronger balance sheet; 3) A focus on new lending and profitability instead of expensive and time-consuming loan practice.

Retail meltdown

With retail being so badly affected, this is a good place to do a market valuation. Unfortunately, things don’t look good for those with significant exposure to CRE retail property loans.

As the Black Friday sales demonstrated, shoppers continue to move online. In-store sales the day after Thanksgiving declined 4% year over year, while online purchases rose 78%. Record-breaking rates of coronavirus infection and government stay-at-home orders have pushed the numbers up. However, this year’s data confirm the ongoing trend towards fewer shopping trips to stationary locations.

Retailers pinning their hopes on a robust post-vaccination recovery should think twice. You may not be there to enjoy the rebound.

By mid-August 2020, 29 major retailers had gone bankrupt. These failures accounted for nearly 6,000 store closures. Coresight Research has an even worse forecast: 25,000 retail store closures by year-end. That adds to the 9,500 retail store closures last year.

Large shopping malls, the traditional pillars of retail, are also heading for the shallows. Morgan Stanley says 30% to 35% of malls will be closed and 20% of malls will likely be sold by real estate mutual funds.

The bankruptcy snowball is already hurtling downhill to bankers and lenders. Vacancies reduce property values ​​and have a negative impact on the loan-to-value ratio. Decreased cash flow – or no cash flow at all – results in defaults, decreased profitability, and lower stock prices for lenders or those whose loans are on the balance sheet.

The office: what is the new normal?

The same dynamic of rising vacancies, strained LTVs and lower cash flows in retail is also changing the office market.

A key takeaway from the pandemic is that employees don’t have to be in the office from home to be productive. This is clearly reflected in the analysis by PwC 2021 Emerging Trends in Real Estate, in which 94% of employers either agree or strongly agree that in the future more employees will be allowed to work from home at least part-time.

The realization that less office space may be needed has shaken office REITs.

Many large tenants in urban centers are negotiating or breaking new leases in REIT-owned buildings. REITs are also selling assets in anticipation of what’s to come. The result is that REIT share prices have fallen by more than 30% this year by the end of November, according to the REIT trade association Nareit.

It is equally important that the attractiveness of large cities, which has been increasing for many years, has come to a standstill due to the pandemic. Although urban life may become more attractive again after the COVID restrictions are lifted, people are opting out of cities for the time being.

Zoom calls and work-from-home have prompted a flight to the smaller metropolises and suburbs. Oracle recently announced that its headquarters would be relocated to Texas, and Goldman Sachs may be relocating a large money management division to Florida.

The multimillion-dollar question is whether the office environment will be busy again before the pandemic. Most likely the answer is no. If that is indeed the case, the shaking in the office space has only just begun.

Is Hospitality at Risk?

The pain in the retail and office markets is just beginning but has been making headlines in the hospitality industry for months. The slowdown in business and leisure travel has decimated hotels and the entire travel industry.

This is reflected in the increasing volume of CRE loan sales secured by hotel real estate. As of August, DebtX has offered more than $ 350 million in hotel loans. Over the past six months, distressed debt funds have raised billions to buy the troubled debt.

Overall, hotel loan prices are now trading 12% to 18% lower than a year ago. It is important to remember that this is not a “discount”. It is the current market pricing. As nostalgic as property owners or banks may be for past values, current value is what it is.

The good news is that there are sectors where CRE credit traded at the same level a year ago. This is the result of a persistent oversupply of buying capital to generate risk-adjusted returns.

Collateral damage from the travel bust and the erosion of cities has also leveled small businesses. Many have always worked on the sidelines, but now they are off the cliff. The volume of small business NPL for sale on DebtX has grown significantly over the past six months. The longer the current and new locks last, the worse it gets.

A glimpse of hope

Rainfall was less severe in two other areas: industry and apartment buildings.

Indeed, industry is a bag of CRE strength. The accelerated adoption of e-commerce has resulted in exceptional demand for warehouse and industrial space, data centers, and demand from logistics companies and other parts of the growing e-commerce supply chain. Amazon alone announced in September that it would be opening 100 new warehouses.

The need for industrial space is also linked to a silver lining: it absorbs the flood of retail vacancies. According to CBRE, 13.8 million square meters of retail space has been converted into 15.5 million square meters of industrial space in the past three years.

In the case of apartment buildings that are only on the water because of government stimulus payments to tenants and PPP business loans, the story was not so positive.

Rents have fallen in 41 of the 100 largest cities, according to the Apartment List National Rent Report. Since March, the haircut has been worst in cities with a high concentration of technicians who can easily do their job remotely. Rents in New York are down 17%, in San Francisco (-23%), Boston (-16%) and Seattle (-12%).

The bottom line for banks and lenders

The good news for banks, and thus also for the US economy, is that many institutions have already set up substantial loan loss provisions.

These reserves can provide a sufficient budget for fast-moving, compromised CRE loans (COVID-affected and pre-COVID issues alike). You can also optimize balance sheets to take advantage of the opportunities after COVID.

This shock absorber should motivate banks and other lenders to sell bad loans to the deepening pool of bad debtors. It’s about how fast bankers will act.

History has shown that banks that get rid of problem loans faster will emerge winners. This virtuous cycle of liquidity and capital reallocation will transform the far-sighted into stronger, more profitable and more impressive institutions.