CRE Finance in a World of Uncertainty – Where are we now
By Jamie Woodwell
March 18, 2020
It has been:
- Nine-and-a-half weeks since the first Coronavirus death was reported in China;
- Eight-and-a-half weeks since the first case was confirmed in the United States;
- Six weeks since the Diamond Princess cruise ship was quarantined in Japan;
- Three weeks since the CDC noted that they expected community spread in the United States;
- Two-and-a-half weeks since the first virus-related death in the United States;
- Two weeks since the Federal Reserve dropped the Fed Funds rate by 50 basis points in an emergency meeting;
- One week since the World Health Organization declared the virus a pandemic;
- One week since President Trump declared a national emergency in the US;
- Four days since the Federal Reserve announced lowering their target range for the Federal Funds rate to 0 to 1/4 percent, a program to purchase Treasuries and MBS and other measures at another emergency meeting; and
- Two days since the Fed announced a program to support commercial paper markets.
There are now more confirmed cases of COVID-19 outside of China than inside.
And as testing has increased within the United States, the number of confirmed cases has jumped to more than 7,500, up from just 1,000 a week ago.
Source: New York Times
The uncertainty about the present and future scope of the virus outbreak has fed confusion and tumult in financial markets. The equity markets have whipsawed over the last week, recording record downs, and trading stops - on both the up and down sides - in response to rapid intraday readjustments.
Comparing where we are today (March 18) to a month ago,
- One month ago, the Dow was at 29,000, today it is below 20,000
- West Texas Intermediate Crude oil was at $52 a barrel, today it is at $22
- The Ten-year Treasury was at 1.55%, today it is at 1.18%
In response to the market gyrations, and to ensure the Treasury and other foundational markets remain in order, the Federal Reserve has taken historic actions, including:
- On March 3, lowering the Fed Funds rate 50 bps in an emergency meeting;
- On March 15, lowering the Fed Funds rate to essentially 0 and announcing Treasury & MBS purchases;
- On March 17, announcing a facility to support the commercial paper markets; and
- Also on March 17, announcing a facility to support investment grade debt markets - including CMBS and CLOs.
Source: MBA, Federal Reserve
During previous weeks, spreads on credit - including CMBS - widened, but not as much as base rates fell, meaning all-in yields (for investors and borrowers) continued to fall. Last week, spreads rose broadly, even in the face of rising base rates - as liquidity concerns took root.
Source: JP Morgan
The impact of the virus, and our public and private response to it, will not begin to show up in most economic releases for several weeks.
One early gauge, the Empire State Manufacturing Index, dropped 34 percent in March to the lowest level since the Global Financial Crisis in 2009. The index for new orders fell 31 points, shipments fell 21 points and optimism about the six-month outlook fell 22 points.
Looking to China for insights into how the virus might affect the US economy in the coming months, during January and February,
- Chinese industrial output declined 13.5% from last year's level;
- Fixed-asset investment declined 24.5%; and
- Retail sales fell 20.5%.
On the plus-side, the Chinese economy is now showing signs of recovery, implying the impact - at least based on their outbreak and response to it - may be severe but also may be relatively short-lived.
To help soften the blow in the US, Congress and the Administration are negotiating "Stage Two" and "Stage Three" stimulus bills that many say will exceed $1 trillion and help both households and businesses work through the coming months.
COMMERCIAL REAL ESTATE MARKETS
How the health, social and economic impacts of the virus flow through to commercial and multifamily properties remains clouded in uncertainty - mainly because of the uncertainty about the virus itself and our public and private responses to it. One thing that is clear is that different property types and different markets will be affected differently.
Hotels remain the property type most immediately and directly affected by the virus. According to S&P, "Smith Travel reported U.S. RevPAR declined nearly 12% in the week ended March 7, 2020. The hardest hit markets for the week were San Francisco (down 46%), Anaheim (down 42%), and Seattle (down 35%), and several other Top 25 markets were down double digits."
William Pate, the President and CEO of the Atlanta Convention & Visitors Bureau noted, "We expect a 56 percent decrease in hotel occupancy for the month of March, an 80 percent decrease in April and a 74 percent decrease in May."
While the lodging industry is feeling the first and most direct impacts of the virus, it is also likely to feel the most immediate and significant rebound. Some cancelled conferences and other activities will not be made-up, but other business and personal travel will - particularly for trips being cancelled today that are being converted to hotel or other credit with an expiration date.
Social distancing policies intended to slow the spread of the virus are increasingly affecting retail establishments. Cities like San Francisco, New York and Washington DC have established policies limiting gathering in bars, restaurants and other establishments. According to the Wall Street Journal, shopping centers such as the King of Prussia mall and the soon-to-be-open American Dream mall have announced temporary closures. National chains like Nike, Apple, Nordstrom, Foot Locker, William Sonoma, J. Crew and others have also announced temporary closures.
Last night Governor Andrew Cuomo announced that New York, Pennsylvania, Connecticut and New Jersey would be temporarily closing indoor portions of retail shopping malls, amusement parks and bowling alleys.
Many large retailers likely have the wherewithal to survive a multiple-month disruption, and to continue to pay rent, but many smaller establishments may not. For property owners, those challenges, added to a partial reliance on percentage rents, could materially affect cash flows.
During natural disasters or other events in which a property is physically damaged, property owners, retailers and other businesses might turn to business interruption insurance for support. Because of the nature of this event, however, that insurance generally may not apply.
Like the lodging industry, however, expectations are that when the virus passes, consumers and retailers may be able to quickly resume pre-outbreak behaviors.
For most office markets, the impact of the current slowdown will likely be muted by the longer-term nature of leases and - one expects - by federal support to tenants. The more immediate impacts will be from a) a diminution in new leasing activity and b) from broader economic disruptions from the virus. Flexible workplaces - with shorter-term leases and generally smaller tenants - may feel the first marginal effects. And markets that are more exposed to harder-hit industries, such as oil and gas, may see more significant impacts. CBRE noted "Energy-dependent office markets, such as Houston and Denver, may experience a more turbulent 2020 due to lower energy demand, lower oil prices and an increase in overseas oil production. Other markets with a concentration in transportation and trade may also see more volatility."
The multifamily market remains among the most remote to the immediate impacts of the virus. The number of households tends to be more resilient during a recession than the number of jobs. The nature of the current situation, however, is different than many other downturns. With restaurants and other establishments closing (most temporarily), the expectation that many households may see reduced paychecks raises the question of how apartment owners can and will respond. In New York, a group of landlords representing 150,000 units pledged not to execute evictions for three months, and was followed by a temporary statewide moratorium on evictions beginning March 16. FHA and the Federal Housing Finance Agency, which oversees Fannie Mae and Freddie Mac, have also made commitments. Federal relief efforts are looking to directly support tenants so they will be able to continue their rent payments.
Certain specialty property types face special situations - including student housing, which is experiencing many school closures during a prime leasing period, and seniors housing, which is experiencing increased operational demands and a virus-related attentiveness from potential residents.
Across all property types, the impacts will depend on the length and severity of the economic slowdown.
Public market sentiment, as evidenced by returns on selected REIT stocks, shows an increased trepidation about the impacts of the virus on commercial real estate, and a keen differentiation by property type. As of COB March 17, REIT stock total returns had (slightly) underperformed the S&P. But storage, manufactured housing, single-family rental and apartments had all outperformed.
Source: Morgan Stanley, as of March 16, 2020
When considering the impacts of a potential recession on the commercial real estate sector, it is also important to note that, while not immune, the longer-term nature of most leases acts as a cushion for the sector - particularly for shorter duration events.
In conversations with MBA members in recent days, three themes emerged:
1) Commercial and multifamily mortgage rates are incredibly low - in some cases at what are likely to be record lows.
2) Lenders are increasingly selective - assessing properties, markets, loan terms and borrower relationships in a time of significant uncertainty.
3) Conditions are in flux - with lender appetites, loan terms and pricing changing day-by-day and even hour-by-hour.
Lenders and borrowers are navigating rapid changes in market conditions and searching for price discovery in a time of dynamic fundamentals. The result has been week-to-week, and even day-to-day or hour-to-hour, changes in decisions about whether to lend, and if so on what terms. The mortgage debt markets remain open, and they are constantly adjusting to the changing conditions.
In assessing loans, lenders need to be cognizant of properties' values and abilities to repay loans. Lenders also need to weigh the relative merits of lending on commercial property versus investing that money in other vehicles.
It is important to note that commercial mortgage debt has been a strong and consistent asset for banks, life insurance companies, the government sponsored enterprises and others - with commercial and multifamily mortgages performing better than any other loan type for banks during the Global Financial Crisis more than a decade ago.
The $3.7 trillion commercial/multifamily mortgage market is supported by a variety of lender types, each of which has a different source of capital, and each of which responds to market changes in a different way. The following observations are taken from conversations with lenders and a) are subject to daily/hourly change and b) may not be indicative of the market as a whole.
The commercial mortgage-backed securities (CMBS) market is the capital source most directly tied to public markets, and thus reacts most immediately to changes. In recent weeks, as base Treasury rates declined, CMBS investors generally required higher spreads, but those spreads rose less than base rates declined, meaning all-in yields on AAA and other CMBS issues generally fell. That changed last week, when long-term Treasury yields rose, as did investor spreads. The result has been a dislocation in the market that makes it difficult for lenders to anticipate the prices at which they will be able to sell loans, and therefore the rates they can quote to borrowers, pushing many lenders to the sidelines.
It is important to note the day-to-day nature of the current situation and that lenders are constantly evaluating both borrower and investor demand to determine what loans and deals may make sense.
The government-sponsored enterprises (GSEs, Fannie Mae and Freddie Mac) and FHA are also closely tied to the capital markets - with bond buyer demand driving much of their appetite and pricing. With a government guarantee on their securities, and being focused predominantly on multifamily properties, credit issues are less of a driver for GSE execution today than for other capital sources. With rates at some of their lowest levels ever, borrower demand and new loan volume has been strong. Even so, changes - in base rates, in spreads that investors are demanding and in concerns about operations in a fully-remote environment - have meant a rapidly changing world of how GSE lenders price their loans. The use of floors, rate locks and other typical elements of the loan process have all changed with market conditions.
Banks generally rely on their deposits and other sources of funding to make commercial mortgages. As mentioned earlier, commercial and multifamily mortgages have been a strong and steady asset for banks, with their charge-off rates being the lowest of any major loan type during the Global Financial Crisis. During today's market disruptions, banks are assessing the credit risks of today's mortgages as well as the relative reward - compared to other loan types like commercial & industrial loans, consumer loans and residential mortgages. Reports are that some banks have taken the recent market volatility as an impetus to pause their lending activity, while others see it as an opportunity to step-up - with a sharp eye on underwriting and pricing given current uncertainty.
Life insurance companies make loans backed by commercial real estate - just as they buy corporate bonds, Treasuries and other assets - as a way to put their premiums to work. In making loans, they assess the risks and rewards of the mortgage itself, and also compare risk-adjusted returns to other assets. The current market volatility has made making those comparison more difficult. As a result, some life companies have paused their originations activity, while others have become more selective in their approach to underwriting, pricing and more. Life companies are generally more conservative than other lenders, and today's market is further demonstrating that. As with other capital sources, different lenders are reacting to the market differently, and generally on a day-by-day basis.
Through all of this, it's worth keeping in mind the fact that there are a number of filters between the economic impact of the virus and impacts on the performance of a mortgage. First the virus or economic spillover has to impact the tenants of a property. Then it has to materially affect the net operating income (NOI), which depends on rents and lease payments, and is further protected by the tenants' own wherewithal. Next it has to flow through from the NOI to the property owner itself, and that owner's wherewithal and long-term interests in the property. And then finally through to the loan, and any overcollateralization. Each of those steps creates a layer of protection for the mortgage from disruptions such as the one we are seeing. And those layers of protection are exactly the reason mortgage rates are lower than equity yields or returns on other elements of the capital stack.
One other factor that is important to note is that as the Coronavirus affects nearly all elements of life and work, it is also affecting commercial mortgage finance operations. Despite the fact that the commercial real estate finance industry tends to trade in knowledge and money, both of which can flow virtually, there are certain actions that require a physical presence. Three that are attracting significant current attention are inspections, physical documents and title recordation. Firms are working through how these and other activities can be supported - and kept from inhibiting transactions - in a remote-working market, even while concerns are already having an impact on some activities, like early rate locking.
Last week we hosted calls of our Peer Business Roundtable groups, which bring together Human Resources professionals, Financial Officers, Marketing Officers and Technology Officers at commercial and multifamily mortgage banking firms. The consistent message we heard was that employees are the number one focus. Firms are working through their travel policies, with a particular focus on client-facing engagements; They are moving from testing to instituting their resilience plans; They are increasing the number of virtual meetings and promoting social distancing; and they are seeing that their investments in technology are being put to the test.
When we look at the way the current situation has unfolded oversees and at our economic forecast, we expect a significant slowdown in economic growth in the second and third quarters of this year. Importantly, we also see economic growth bouncing back in 2021 as the impacts of the virus fade.
As we've said before, the bad news is that there is a great deal of uncertainty about how the virus will play out in the US, how we will react publicly and privately and what the impact will be on the economy. The good news is that the economy and commercial real estate markets are entering this period from a position of considerable strength.