The Commercial Mortgage Market Since the Covid-19 Pandemic
The COVID-19 pandemic has caused disruption to many facets of what was once everyday life. As Americans sheltered in place, brick-and-mortar retail shopping and travel came to an abrupt halt. Those who could do so began working from home, while many who couldn’t found themselves furloughed or unemployed. An inevitable consequence of this disruption is that malls and hotels sit underutilized and owners of office properties and multi-family housing have granted rent concessions. Many commercial property owners, even owners of historically well-performing properties, are now struggling to make mortgage loan payments. Hospitality and retail properties have suffered the greatest losses, but office and certain segments of multi-family housing have also suffered significant hits.
For investors in commercial mortgage-backed securities (“CMBS”) — i.e. bonds backed by mortgage loan payments secured by commercial properties—the distress in the commercial real estate market means that the value of their investments may experience losses. As an example, the Financial Times, in an August 2020 article, wrote about the fate of America’s oldest continuously running hotel, the Palmer House Hilton in Chicago, which suspended operations in April. It was reported that more than 90 percent of the hotel’s 900 person staff has been furloughed. Moody’s has downgraded some tranches of the bonds in the CMBS transaction that Palmer House Hilton backed to a junk rating. (“Pandemic exposes ‘severe stress’ in commercial property financing,” Financial Times, August 31, 2020.)
“We could simply have less demand for commercial real estate… My biggest fear is that the sharp rebound we are hoping for doesn’t materialize.” – Financial Times, August 31, 2020
A CMBS transaction begins with one or more commercial mortgage loans either originated or acquired by a financial institution and sold to a CMBS trust. The trust then issues bonds backed by payments on the mortgage loans with the underlying commercial property acting as collateral. A servicer collects payments on the loans and distributes the payments to the trust. When loans become delinquent, a special servicer steps in to manage the properties and make certain major decisions relating to the property, including granting of forbearance or foreclosing on the underlying property.
Record numbers of CMBS loans have entered special servicing in 2020—approximately 13.36% (at its height in May) of the $1.4 trillion market. (“Borrowers Giving Back the Keys to Their Properties in Droves,” Trepp, October 22, 2020). The CMBS delinquency rate has since declined to 8.92% as of September, 2020 (“Early October Indicators Point to Drop in Delinquencies,” Trepp, October 23, 2020), but special servicing remains high, due to approximately $31.2 billion of outstanding CMBS loans being granted some form of forbearance through September of this year (“CMBS Loan Forbearance Volume Surges Over the Last Two Months,” Trepp, October 2, 2020) . Perhaps even more alarming, borrowers of approximately $3.9 billion of outstanding CMBS loans have indicated that they would be willing to return the collateral to lenders in lieu of loan modifications or forbearances. (“Borrowers Giving Back the Keys to Their Properties in Droves,” Trepp, October 22, 2020).
The bulk of delinquent CMBS loans—approximately 26% according to Trepp’s October 2020 CMBS Delinquency Report —are secured by hospitality properties with the Portland-Vancouver-Hillsboro metropolitan statistical area leading with approximately 78% of its hospitality CMBS loans in default (“Hotel Real Estate Feeling the Pain: Where is the CMBS Distress in the United States," Trepp, October 14, 2020) . The retail sector was faltering even prior to the pandemic due to numerous large retailers announcing store closures or bankruptcy. The pandemic, of course, has only heightened distress in the retail market. Loans backed by retail properties also have a delinquency rate of roughly 15%, reflecting that approximately $18 billion in retail CMBS loans are at least 30 days delinquent. As of October, even ground floor retail rents in Manhattan, well-known for high space demand and correspondingly high rental rates, have dropped approximately 12.8% from 2019 (“Asking Rents for Manhattan Ground-Floor Retail Space Decline 12.8% in Q3,” Trepp, October 15, 2020.) Loans secured by office properties, too, are faltering, though at a much lower rate. However, of the $145 billion outstanding office CMBS loans as of September 2020, approximately one third have major tenants whose leases expire in 2022 (“National Report: The Impact of the COVID Disruption on the Office Segment,” Trepp, September 2020.) Given that businesses may scale back on office space as work-from-home becomes more of norm, office property loans may have the worst ahead.
There are, however, a few segments of commercial real estate that are performing well. As brick-and-mortar shopping has all but ceased, online shopping has increased. As a consequence, loans backed by industrial warehouses acting as distribution centers and other logistics hubs are performing well. Self-storage, an industry considered to be “recession resistant” is also performing well, particularly as residents down-size as a result of the wider economic downturn. Both sectors are performing well enough that some retail properties are converting or are considering conversion despite the ordinarily lower valuation of such properties.
Conflicting Views as to Loss Causation May Lead to Increased Litigation and Enforcement
“A well-documented historical pattern is that fraud thrives in boom periods and is revealed in busts…” – University of Texas, August 10, 2020.
“No one underwrote for global pandemic.” – Commercial Real Estate Finance Council
Certain sources are beginning to question CMBS underwriting standards as COVID-19 has shined a light on the sector. A University of Texas study published in August, along with articles in the Wall Street Journal and ProPublica, argue that the problems facing the CMBS market are not only due to COVID-19, but that COVID-19 may have accelerated the effects of underwriting standards and alleged fraud in the origination of CMBS loans. The University of Texas study examined CMBS loans originated from 2013 to 2019, finding that actual net operating income (“NOI”) is often lower than the underwritten NOI, an overstatement that the study argues can result in a loan that is riskier than it looks. In a similar vein, a whistleblower complaint submitted to the SEC alleges that lenders and issuers “have regularly altered financial data for commercial properties … in ways that make the properties appear more valuable, and borrowers more creditworthy, than they actually are.” (ProPublica, May 15, 2020.)
That said, many industry professionals and groups disagree and place accountability for performance faults squarely on the pandemic. Trepp, a leading commercial real estate data and analytics provider, performed an independent analysis and found that NOI does not differ as substantially from the underwritten levels and—when analysis was run looking at maximum NOI levels—actual NOI was actually higher overall. The Commercial Real Estate Finance Council (“CREFC”), too, issued a rebuttal to the fraud allegations. CREFC notes that COVID-19’s impact on loan performance is overstated, given its overall massive global impact. Like Trepp, CREFC also argues that the studies conducted are flawed and show a misunderstanding of the relationship between actual NOI and underwritten NOI.
“‘The SEC has been aware of potential income inflation in CMBS loans since at least February 2019, when it received a complaint about the Issue.’” – Wall Street Journal, August 11, 2020.
Such allegations about CMBS loan origination are reminiscent of the allegations made about residential mortgage-backed securities (“RMBS”) loans that contributed to the 2008 economic crisis. As has been widely reported, at the time, the prevailing allegations were that such loans were often made to borrowers with unverified income or were secured by homes that had been improperly valued. The scrutiny that CMBS is currently facing may indicate that law suits and regulatory scrutiny are soon forthcoming. In response, King & Spalding has assembled a multidisciplinary team of attorneys to prepare financial institutions for a possible coming storm of litigation and enforcement. The team is comprised of attorneys from the securities enforcement, litigation, real estate and structured finance groups. Within this team are multiple attorneys who defended the SEC and DOJ CMBS and RMBS investigations, a former acting Attorney General, an attorney who represented the SEC on the President’s RMBS Working Group and another who was instrumental in forming the SEC’s CMBS Working Group, a litigation team named as a top three “Powerhouse” firm for complex commercial litigation by BTI Consulting, and real estate finance and securitization professionals whose practices cover the spectrum of the real estate finance transactional life cycle.