Storm building around commercial sector
Mortgage-backed securities may be next flashpoint in economic crisis amid soaring vacancies, missed payments
The coronavirus pandemic and the resulting economic crisis is driving dramatic and long-term changes in the commercial real estate industry as e-commerce adds to its dominance and companies cut overhead costs by keeping employees working from home.
These changes not only pose threats to the companies that build and lease office towers, retail centers, industrial complexes and apartment buildings, but also to the banks, life insurance companies and pension funds that invest in them. Ultimately, how far the crisis and the disruptions it causes reach into the financial system could determine how quickly the commercial real estate sector recovers from the downturn.
Commercial real estate investors are confronting issues similar to those faced by investors in residential real estate in the years leading up to the housing bust of more than a decade ago. As with homes, most commercial properties are purchased with mortgages, which are then bundled into securities and sold to investors, whose returns depend on property owners making their monthly payments.
With businesses struggling after governmentordered shutdowns and other social distancing measures, cash-strapped commercial tenants are missing lease payments and their landlords missing mortgage payments, undermining the value of the mortgagebacked securities. If the debt goes bad, it could blow a hole in the balance sheets of investors, dry up the capital needed to revive the commercial real estate market, and hurt the returns of institutions, such as pension funds, on which millions of Americans depend.
Private pension funds own about $30.3 billion in commercial mortgages, according to the Federal Reserve.
“How bad it’s going to be — I don’t know,” said Jeff Davis, managing director of the financial advisory firm Mercer Capital. “It’s a stinking mess is what it is.”
More than 6,700 borrowers have reached out to their servicers asking about relief options on $149 billion in outstanding commercial
mortgages that have been bundled into securities, according to credit ratings agency Fitch Ratings (Fitch is owned by Hearst, which also owns the Houston Chronicle). And more than $52 billion worth of mortgages backing securities missed their April 1 rent payment, according to the securities data company Trepp.
While all commercial real estate debt is at risk, mortgages that are packaged into securities tend to cover a larger percentage of a property’s value. What’s more, many of the mortgages are interestonly, meaning borrowers never pay down the principal amount of money they borrowed.
That’s a risk if rental incomes dry up and property values fall, because the foreclosure on the asset may not recoup the money that was lent, leaving a hole in the balance sheets of those who own the debt. The potential impact extends beyond the financial sector — according to the Federal Reserve, private pension funds owned $30.3 billion.
The situation has echoes of the collapse of the market for residential mortgage-backed securities, which was at the heart of the financial crisis that began in 2007. But experts say the situation today is not as dire. While unscrupulous lending was rife during the leadup to the Great Recession, often requiring zero percent down, commercial mortgages currently bundled into securities generally do not cover more than 75 percent of a building’s value. That means the building’s value would have to fall by more than 25 percent before a landlord owes more than the asset is worth.
(A 2019 whistleblower complaint filed with the Securities Exchange Commission alleged lenders and security issuers have artificially inflated financial data in order to make larger loans, according to a ProPublica report. That would mean those mortgages cover a larger percentage of the properties’ values – and hold a higher risk – than investors had realized.)
Value risk
Because commercial real estate derives much of its value from the rents, values could fall if tenants fail and remaining businesses have less need for physical space.
“People are going to offer fractions of what they offered before for properties,” said Manus Clancy, senior managing director at Trepp. “You’re going to see values go down — for offices, retail, hotels, etc.”
The potential hit to commercial real estate will depend on demand for commercial space coming out of the shutdown.
On one end of the spectrum of possible outcomes, if business soon returns to usual, Davis believes the period of missed rents will be an inconvenience with little impact on real estate values.
But on the other end of possible outcomes, if enough businesses go under to drive up vacancy rates and a pivot to a digital economy means companies that remain need less retail and office space, there will be a glut of commercial space on the market, driving down prices at the same time that landlords are likeliest to default.
“In that scenario, the value of the underlying collateral for commercial mortgages is meaningfully impaired, meaning it has fallen dramatically because the cash flows from a given development have just declined,” Davis said. “The bottom line is what’s going on is not good for the commercial mortgage industry.”
Congress has moved swiftly to prevent the mass residential foreclosures that can cause home values to spiral downward, but aid meant to help small businesses pay rent — called the Paycheck Protection Program — has run into numerous snags. Only 60 percent of local small businesses who have applied for assistance through federal stimulus programs rolled out in March have received it by the end of April, according to a survey conducted by the Greater Houston Partnership, an economic development group.
The rest were left to negotiate rents with their landlords, many of whom had to ask for help on their own monthly obligations. Those with loans that have been packaged into commercial mortgagebacked securities face greater hurdles than those owned by banks.
George Marshall, an executive director at Amegy Bank, said that every one of the bank’s clients that operates a hotel has asked for relief, as have many of its shopping center owners and investors. Amegy retains its loans, instead of selling them off as parts of commercial mortgage-backed securities, and has been able to quickly provide such relief by substantially reducing up to six months of payments for customers that have had revenues impacted by the pandemic.
Market ‘seized up’
When a landlord with a loan that has been packaged in a commercial mortgage-backed security tries to seek relief, the process is much more complicated, explained Brian Stoffers, global president of debt and structured refinance at commercial real estate firm CBRE.
Different companies manage loan payments, and securities are split into various pieces, known as tranches, that represent a pecking order of who gets repaid first. The tranches that will only be repaid after other investors are known as B-pieces in the finance world, and the largest holders of that high-risk debt include asset managers and special servicers such as Rialto Capital Advisors, KKR Real Estate Credit, Eightfold Real Estate Capital and Prime Finance, according to Trepp data.
“It’s become difficult for buyers with existing loans that need forbearance to get relief … because of the ways the bonds were created and the different levels of approval that are needed to get forbearance,” Stoffers said.
Landlords with loans packaged in commercial mortgage-backed security could also face challenges because the loans were riskier to begin with. “Those are loans that are typically more aggressively underwritten,” Stoffers said. “They have higher loan values, higher rates, and they’ll lend on a broader array of property types and qualities.”
As a result, few are currently willing to buy commercial mortgagebacked securities, essentially freezing the market, he explained.
“That market has seized up,” he said. “If you’ve aggregated it pre-COVID and the market turns, you’re now holding a portfolio of returns that are worth a whole lot less than what you originated.”
Commercial mortgagebacked securities are currently reporting how many of their loans missed their May payments. Of the roughly 70 percent that have already reported, 7.3 percent of loans – and 19 percent of hotel and retail loans — are at least 30 days delinquent. “All those statistics are front and center right now, kind of the same way subprime mortgages were front and center during the last financial crisis,” Clancy said.