Below is an article authored by Dianne Crocker, principal analyst, LightBox that was just published in the Fall edition of the EBA Journal. The article focuses on how to commercial real estate industry is starting to recover from its low point earlier this year. Thanks to the Environmental Bankers Association for permission to reprint this article here. To read the full EBA Summer Journal, visit EnviroBank.org.
When I wrote the market update that appeared in the summer edition of this Journal back in early June, we were just two and a half months into the lockdown triggered by the COVID-19 pandemic. The U.S. economy had just slipped into a recession, ending a record-long recovery. The once-robust pace of commercial real estate deals plummeted, construction projects halted, all but our most essential businesses closed, schools went remote and we hunkered down with Zoom from our homes.
Now as the final quarter of a truly unusual year gets underway, the commercial real estate market is slowly and steadily improving, investor confidence is rising as they move off the sidelines and U.S. Phase I ESA volume is at its highest levels since the pandemic hit. In this article, I summarize the current state of the commercial real estate lending sector and highlight what to expect as the next stage of the pandemic reveals itself.
More Conservative Underwriting
In this edition’s Ask a Lender column, EBA members shared their thoughts on transitioning from a busy spring processing PPP loans to more traditional renewals or refinancing of existing loans, new loan originations, and some early foreclosure activity. Seven months into the pandemic, debt markets are adjusting and once again becoming active, with loan underwriting standards conservative to reflect the as yet unknown length of the pandemic. Some risk managers are adjusting lending criteria to be more stringent, and even taking into consideration second sources of funds in the case of future default.
Thus far, banks have been accommodating by exercising forbearance, and extending or restructuring loans to offer relief to struggling borrowers. As forbearance periods are expiring, lenders will be starting the process of making difficult “forbear or foreclose?” decisions and addressing what to do about nonperforming assets. The moratoriums on foreclosures and evictions in several states including New York limit the options of lenders and landlords, but foreclosures are already rising in areas like the Southeast U.S. that do not have such protections in place.
It is difficult to predict how the next few quarters will play out, particularly as negotiations for a new wave of fiscal stimulus hang in the balance. Lenders are turning a critical eye to the loans in their portfolio to identify those most at-risk of default as they prepare for potential distress, dispositions, and foreclosures, as well as staffing up with experienced workout personnel. Loans associated with the hard-hit hospitality/travel, restaurant, and retail sectors will likely be the most vulnerable.
Bracing for Distress
As the most transparent segment of commercial real estate lending, the CMBS sector provide an early window into what we might expect in terms of distress. The September report from Trepp LLC contained a look at how delinquency and special servicing rates trended during the last financial crisis and this one. Special servicing rates have consistently increased since March, climbing up to 10.5% in September from 2.8% in March. As of September, 26% of hotel-backed CMBS loans were in special servicing, and 18.3% of CMBS loans tied to commercial retail properties. Both sectors’ special servicing rates are the highest on record, while industrial, office, and multifamily all have below 3% of their CMBS loans in special servicing. In addition to the more than 1,900 loans currently in special servicing, Trepp estimates that there are more than 4,900 on the special servicer watchlist, representing about 20 percent of outstanding CMBS loans. The overall special servicing rate is expected to continue to increase in coming months and is “logging the same increasing trend as witnessed in 2009 during the last financial crisis.” Over the coming months, an increase in lenders taking possession of properties with delinquent CMBS loans is likely.
While the size of the wave remains to be seen, it is highly like that the distressed cycle will play out in the next six to twelve months. Before then, the market will go through a “discovery phase” of determining just how deep the pandemic-driven property value declines will go. Early data show that the value of the collateral for CMBS has been written down by 27 percent on average based on the new appraisals done as loans move into special servicing. Hotel properties experienced the sharpest drop in value, followed by retail.
As each month of data reveals growing stress on property owners, firms are actively raising funds and looking to buy distressed debt. During every down cycle, distressed asset buyers wait in the wings for market values to bottom out before moving in to aggressively look for opportunities.
Phase I ESA Activity Rebounds
A review of Phase I environmental site assessment activity over the past four months illustrates just how far the market has come. Shelter-in-place directives in April and May triggered dramatic drops in ESA activity that erased growth from a relatively strong first quarter. Since then, each month has been another step closer to normal. By September, the market was performing at monthly levels more consistent with the early months of 2020, and only three percent below September 2019.
Despite the 37% and 44% declines of April and May, year-to-date volume for the first nine months of the year is 11% below 2019 levels. Typically, in a Presidential election year, transaction activity is stronger in the first half of the year as investors try to get big deals done in the first half, anticipating a pull to the sidelines as we get closer to Election Day. This year, however, with the pandemic putting on the brakes in March, the past few months brought an increase in dealmaking as well as strong refi activity that fueled demand for Phase I ESAs.
While U.S. Phase I ESA volume paints a picture of gradual recovery, a look at metrolevel performance reveals stark geographic differences in the pace of recovery. Based on an analysis of Phase I activity in the largest 20 markets for environmental due diligence using the LightBox ScoreKeeper model, six metros outperformed the average 3Q20 growth rate of the past three years. Cities were particularly hard hit by COVID-19 so it is not surprising to see that metros like Seattle, Chicago and New York City are still struggling. A metro’s recovery rate will not only depend on the severity of the rate of infections but also its vulnerability to the hardest-hit sectors of real estate. Metros with a heavy reliance on hospitality, travel, retail, and restaurants will recover more slowly than ones that are a big draw for technology firms or industrial investors, for example. Tech markets like Dallas, Denver, Atlanta, and Salt Lake City will benefit from stronger investment activity, along with industrial hubs like Phoenix, Atlanta, and Dallas.
Asset Class Differences
While lenders have certainly become more conservative in their underwriting, banks are still actively lending with a strong preference for some asset types over others. Industrial properties that support strong e-commerce activity in growth metros are a desirable asset class, along with medical, logistics, self-storage, and essential retail.
Office and retail are two sectors whose challenges were really brought to the surface by the health crisis. Prior to COVID-19, the retail sector’s struggle against e-commerce was well told. Today, not only have the owners of “nonessential” stores had to cope with extended closures but an even broader swath of the population now routinely shops online, making the environment for brick and mortar stores that much more challenging. Thus, it is more difficult to secure financing for loans in struggling sectors like retail, hospitality, restaurants, movie theaters, and gyms.
Over the longer term, the market will see more interest in repurposing properties for new uses that reflect changing consumer preferences. Retail is where the market will likely see the greatest pain and the greatest potential. There will be opportunities for closed stores to be repurposed into new uses for in-demand services like medical facilities, housing or distribution centers. Others will be reinvented into more experiential shopping spaces. Some hotels may be transitioned to meet demand for new flexible office space. Another impact of the pandemic can be found in the office sector, which was already suffering from oversupply in many urban areas prior to COVID-19. After months of managing a WFH staff, there’s not a CEO out there who’s not considering flexible work options and a reduction in their office space footprint post-COVID. Some have already opted to decrease their downtown office footprint in favor of suburban office hubs that require shorter commutes by employees.
As one analyst said recently, “The significant uncertainties in the market make it impossible to forecast more than a month out.” The good news is that commercial real estate investors are comfortable looking at properties again, but if the final quarter brings a dramatic increase in COVID-19 cases, we could see reinstatement of shelter-in-place directives and market confidence could take a hit. Then there’s the problem of distress and just how deep it will go. And of course, the ongoing pandemic.
The reality is that market recovery cannot happen until the health crisis ends, and that will not happen until there is a widely available, reliable vaccine for COVID-19. Notwithstanding that fact, there are several factors that bode well for the market, including the strength of the market leading into the pandemic, and disciplined risk management by lenders. While the relative strength of the market varies considerably now by asset class and metro, there is a tremendous amount of capital on the sidelines poised to pounce when pricing is attractive to buyers.
As federal assistance that protected property owners from the impacts of rent non-payment fade, foreclosures, and the level of distressed assets in the market will increase. The market is mobilizing for distress, but no one knows when it will come or how bad it will be. Debt funds are ready to take advantage of distressed opportunities at the right price, and there will likely be more reliance on auctions as an avenue for reaching prospective buyers to divest properties quickly and efficiently. Buyers are warned to conduct solid environmental due diligence to avoid inheriting any contamination liability from prior owners.
Market indicators right now suggest that the path ahead will be very uneven. Certain asset classes will fare better than others, as will certain metros. Forecasts reflect an expectation of an uptick in refinancing, foreclosures, auctions, and default transactions in the fourth quarter and early into 2021, particularly in areas hardest hit by the pandemic.
To end on a positive note, the Urban Land Institute and PwC released the 42nd annual Emerging Trends in Real Estate 2021 report. The report unveils the Top 10 Emerging Metros for 2021 as the cities offering the strongest investment and development prospects:
- Raleigh/Durham, NC
- Austin, TX
- Nashville, TN
- Dallas/Fort Worth, TX
- Charlotte, NC
- Tampa/St. Petersburg, FL
- Salt Lake City
- Washington, D.C./ North Virginia
- Long Island, NY
If your institution is lending in these metros, you could see stronger activity next year due to factors like an attractive quality of life and a healthy mix of industrial sectors boosting up the local economy.