Coronavirus, Treasuries and CRE Finance
By Jamie Woodwell
March 2, 2020
Last week, the week of February 24, 2020, financial markets recognized that the Coronavirus has arrived in the United States. Prior to that, most articles and analyst reports that discussed the economic impact of the virus focused on declines in foreign demand for US goods, or disruptions to international supply chains. With community-spread cases detected in the US, that focus began to turn inward.
The first death from the virus was reported in China on January 11. A month and a half later, the global death toll nears 3,000, with the vast majority of cases still in that country. In recent weeks, the rate of increase of COVID-19 cases in China has slowed, while cases in other parts of the world have grown.
On Tuesday, February 25, Nancy Messonnier, the director of the National Center for Immunization and Respiratory Diseases at the CDC, noted, "Ultimately, we expect we will see community spread in the United States. It's not a question of if this will happen, but when this will happen, and how many people in this country will have severe illnesses."
As of February 29, the Centers for Disease Control (CDC) reported 47 cases among people repatriated to the US and 15 confirmed cases among people other than those who had been returned to the US through State Department flights. These include cases in Arizona, California, Illinois, Massachusetts, Oregon, Washington and Wisconsin. Additional cases have now been identified in Florida, New York and Rhode Island.
* This map represents cases detected and tested in the United States through U.S. public health surveillance systems since January 21, 2020. It does not include people who returned to the U.S. via State Department-chartered flights.
The change in the perception of Coronavirus from an external to an internal threat to the US economy had a sudden and dramatic impact on domestic financial markets, which had already been bracing for a potential slowdown due to the lingering effects of the trade war. This last week,
- The Dow Jones Industrial Average fell 12.4%, or 3500 points, capping its worst month since 2009;
- West Texas Intermediate Crude oil prices fell below $44.00 per barrel, the lowest in more than a year;
- The Ten-year Treasury yield fell below 1.2 percent, a record low, on the largest weekly decline since December 2008;
- The Two-year Treasury yield fell to 0.9 percent in the largest weekly decline since September 2001; and
- Futures markets now predict a 100% chance of a Fed rate cut at its March 17-18 meeting, up from an 11% chance just one week ago. (MBA is forecasting a 50 basis-point cut at the March meeting.)
COMMERCIAL REAL ESTATE (CRE) FINANCE
The rapid drop in rates led to what some described as a "crazy" or "stressful" week in commercial real estate finance markets. Perhaps even more so, the week brought with it uncertainty.
Borrowers and lenders alike are trying to understand the degree to which recent rate and other changes are temporary and how the market will adjust to them.
For borrowers, last week's thirty-basis point drop in Treasury yields raised the hope of saving on debt service. Lenders and originators report that many borrowers took the opportunity to reach out about refinancing or converting debt from floating to fixed-rate, and that acquisition deals seemed far easier to "pencil out" with the lower rates. Many of those with loans in process sought information on how to take advantage of the new rates. All of this led to increases in the volume and pace of borrower interactions and requests.
For lenders, the rapid change in rates prompted uncertainty and a critical need for price discovery. While equity and bond prices are continuously and publicly updated, market prices for commercial mortgages are more heterogenous and can take far longer to settle. Lenders from life companies to banks to the government sponsored enterprises (GSEs) are working to identify the absolute rates they need to justify investment in commercial mortgages, and how those levels relate to where the markets are currently.
Life insurance companies and banks make commercial mortgages to earn a spread relative to the costs of their liabilities, premiums and deposits. Hence mortgage rates are driven by yield targets tied to those products. Those targets mean that many life companies and banks may not rush to adjust their pricing to these rapidly lower interest rates, and instead will take time to see if the lower rates are here to stay and to allow some of the uncertainty to dissipate. The use of floors on the rates they quote is an important tool in this process, particularly for life insurance companies, and is discussed in the appendix.
The commercial mortgage-backed securities (CMBS) market and the GSEs have funding that is more directly tied to the public capital markets, and therefore adjusts almost instantaneously to changes in rates such as we've seen over the last week. There are some frictions, such as warehousing risk, that can lead these lenders to follow rates cautiously, but their response to market changes should be relatively direct. Like life companies, Fannie Mae and Freddie Mac have floors in place that limit the full adjustment to new, rapidly lower base rates. During the last week, CMBS bonds outperformed corporate debt, demonstrating greater investor confidence in the secured nature of the mortgages, the call protection of the bonds and how the virus may affect CRE markets. Reports are that CMBS lenders continue to make new loans and issue securities, although some end-investors may also proceed cautiously in the face of record low absolute yields.
Across capital sources, the rapid drop in rates has left mortgage banking professionals cautious and in search of price discovery and insights into where the market will now clear.
Turning to US commercial property markets, thus far the impact of the virus has been muted and narrow, and largely driven by conditions outside the US. The full impact will be determined by the size and scope of the outbreak domestically and how we react to it - both the public and private sectors.
Hotels are the property type most immediately and directly affected. Since the outbreak, more than 200,000 flights to, from and within China have been cancelled. Given that China is the largest outbound travel market in the world, the outbreak has already begun to act as a drag on hotel markets that are reliant on those travelers. This last week, Facebook and Apple cancelled domestic events that would have brought together large numbers of employees and customers here in the US. Amazon and others have announced new limits on employee travel in the US and internationally. These types of steps will likely increase as the domestic response - both public and private - evolves. The impact on hotel bottom-lines will be rapid and direct, as will any bounce-back in travel activity, with the long-term effect dependent on the length and severity of the US outbreak and response.
Impacts on industrial properties are less direct and more muted. Global supply chains have been hit by the severity of the virus and quarantines in China. There was an estimated 25% drop in container traffic volumes in February at the Port of Los Angeles. US companies have worked to keep their supply chains functioning, but most economists have expected the disruptions to weigh on manufacturing and production. The decline in throughput has been expected to be temporary, meaning little overall impact on the demand for industrial space - although perhaps a slower increase in demand for space in the coming months. This last week's equity sell-off and the rise in corporate debt spreads signal a change in the level of concern about overall corporate health. For individual properties, the most likely impact is not from specific virus-related declines in property fundamentals, but rather indirect effects from a more pronounced and short-lived economic slowdown, and spill-overs to demand.
Retail properties have been under a cloud for many years due to excess space and the rise of ecommerce, and the Coronavirus adds another item to the watchlist. Last year's trade war had raised the cost of consumer goods, increasing concerns about retail demand. Over the last month, virus-related trade disruptions added to that and raised an additional specter of diminished availability of products like the iPhone. As with industrial, however, those impacts were unlikely to significantly affect the demand for space, and as of last week, most retailers continued to focus on the impacts of the virus on their Chinese locations. For US retail property markets, the key question will be the spread of, and response to, the virus domestically. If the virus becomes more widespread, overall retail sales could fall, perhaps significantly, for a period of time, particularly in gathering places like large malls. For domestic properties that may already be facing some level of stress, impacts from a US-based virus outbreak could have a knock-on effect. The shorter and less severe any outbreak and reaction is, the less of an impact it will have on retail sales and properties' operations.
Office properties, with long-term leases that aren't tied to sales or other metrics, are more immune to the economic impacts of the virus. It is likely that just as companies are reducing employee travel, many may institute work-from-home and other programs if the virus is expected in their communities. These efforts would be temporary and should not impact overall office demand in the near-term. They may, however, act as a forced experiment for many firms in how they operate with a telecommuting workforce. The stock price for Zoom Video, a maker of telecommuting software, is up 21 percent over the last month. But it is just as likely firms will find negative as positive lessons from a period of forced-remote-work. Shorter-term, the domestic spread of the virus does significantly increase the chances of a recession in the coming quarters, so any concerns about office market dynamics should mainly be through the indirect effects of a broader economic slowdown that alters demand for space.
Among different property types, multifamily is perhaps the most remote from impacts of the virus and may be seen as a "risk-off" in the current environment. The virus is unlikely to directly affect the demand for apartments and would do so only longer-term through any indirect impacts of a broader economic slowdown. At least initially, construction of new multifamily properties may not be impacted, but if the availability of key materials is affected by supply chain disruptions, the pace of building could slow.
With all this being said, there are signs that US commercial real estate markets - with long-term leases, secured collateral and, in most cases, being many steps removed from direct impacts of the virus - are a relatively safe harbor in the uncertainty of the global and domestic markets. The fact that the 10-Treasury yields fell by 30 basis points during the week while CMBS AAA spreads widened by only 14, is one early piece of evidence that financial markets view CRE and CRE debt relatively positively.
This last week brought with it a change in the perceived threat to the US economy from the Coronavirus, and financial markets adjusted immediately. Commercial real estate markets and CRE debt are slower to adjust and will be doing so over the coming weeks and months.
The bad news is that the spread of the virus domestically, our public and private response to it and how those affect the markets are sources of great uncertainty. The good news is that commercial real estate markets are coming to this period in a position of considerable strength.
We will continue to monitor the situation closely and provide additional information and insights as they unfold. Please let us know if you have particular questions or observations and if there is additional information that would be of value.
One tool lenders use to cushion the impacts of rapid rate changes, such as this, is interest rate floors.
Commercial mortgage rates tend to come in two parts - a base rate and a spread. The base rate may be a Treasury, LIBOR or other yield intended to roughly track a lender's cost of capital for a specific term of borrowing or lending. The spread adds lender-specific capital costs, compensation for the risk of the individual loan and lender return. Lenders generally quote commercial mortgage rates as the two separate components - committing to a certain spread, with the base rate to be determined when the mortgage rate is locked.
In recent years, base rates have been trending down - with the Ten-year Treasury averaging 2.71 percent in January 2019 and 1.71 in January 2020. Competition among lenders has kept spreads tight, even tightening, over that period, meaning that all-in rates to borrowers have declined considerably.
Ten-Year Treasury Yield
The drop in Treasury yields or other base rates does not necessarily flow through to a lender's cost of capital (which can be driven by premiums for life companies or deposits for banks). For this reason, many lenders institute "floors" when quoting commercial mortgage rates. With a floor, the lender gives a quote for a specific loan spread, but with a recognition that if base rates drop by the time of rate lock, the all-in mortgage rate will not go below some pre-determined level.
For many portfolio and other lenders, the floors recognize that the lender requires some base level of yield or compensation on their loans. Otherwise, lending the money might not make sense.
The drop in rates over the last week has activated floors across a range of commercial mortgage capital sources - from life insurance companies to the government-sponsored enterprises (Fannie Mae and Freddie Mac) to others. For borrowers with loans that have been quoted but not yet rate locked, that means that their mortgage rate, when locked, may not decline in direct relation with a decline in base rates.
Lenders may adjust floors as competition and market conditions change over time. After a rate drop, if a lender expects rates to remain low, they may reduce their floor as a lever to be more competitive. On the other hand, if a lender expects rates to rebound, they are more likely to hold their floors, even in the face of increased competition. In periods such as this, with considerable market uncertainty, companies using floors will often accept a pause in activity to see how the overall market reacts.