Amid the broad uncertainty gripping real estate markets, there are growing concerns about the state of CMBS. That’s especially the case given the experience of the Great Recession, when delinquencies on conduit loans exceeded other categories and heavy government intervention was necessary to stabilize the market.
Experts are expecting that CMBS will face high delinquencies again, but have also said that the government’s quick decision to get the term asset-backed securities loan facility (TALF) up and running quickly and some of the other measures that were applied to secure the sector after the last crisis make for a better outlook this time around.
The CRE Finance Council (CREFC) has been heavily active in the industry’s efforts to lobby for the inclusion of CMBS in TALF. The group continues to push for additional measures, including assistance for both the secondary and primary CMBS markets and further expansion of TALF to include investment-grade single-asset/single-borrower (SASB) CMBS and AAA-rated collateralized loan obligations.
The group also published a borrower’s guide aimed at helping CMBS borrowers navigate the current climate.
NREI spoke with Lisa Pendergast, executive director at CREFC, about the CMBS market, the group’s efforts and how this cycle might look compared to the Great Recession.
This Q&A has been edited for style and clarity.
NREI: What are some tips for owners and servicers in situations where people are having trouble paying their loans right now? What are some of the options available to help work through the immediate pain and try to come out of this minimizing delinquencies/defaults?
Lisa Pendergast: The CMBS industry has been working diligently with borrowers and investors to navigate these unprecedented times with empathy and compassion. CREFC’s servicer members have confirmed that they have reassured borrowers that in this time of COVID-19, lenders and servicers recognize many property owners are experiencing significant interruptions to their cash flows and property operations and that relief is available.
Recognizing that the extent to which COVID-19 impacts property cash flow varies, borrowers should continue to make their loan payments if possible. When such payments are no longer possible, CMBS servicers are able to discuss potential remediation strategies for those borrowers who entered this period in good standing. Such remediation could span the spectrum from applying loan reserves to mortgage payments to working with the borrower to construct a forbearance program for a pre-defined period. Requests for relief must be reasonable and fit the circumstances of the property, loan structure and borrower, as well as meet the credit requirements of the lender (servicer) and the terms of the pooling and servicing agreement for the specific CMBS trust.
While there is no one-size-fits all solution, CREFC published on March 31, 2020 guidance for CMBS borrowers, “A CMBS Borrower’s Quick Guide for Communicating with Your Servicer in Cases of Need.”
The guidance encourages owners of all types of commercial real estate (including hotels, retail buildings, multifamily housing, industrial/warehouse facilities and office buildings) to communicate directly with their servicer according to the directions provided in the servicer’s communication, web portal, billing statements, payment advice and/or other correspondence.
NREI: Talk about the experience of the last cycle. From what I remember, the opportunities for distressed properties and debt didn’t emerge immediately, but took some time to get to the market. But then we had a multi-year period where investors in distressed debt and real estate had a lot of opportunities that ended up delivering returns. Do you expect a similar kind of process? What does this mean for conduit lenders and servicers?
Lisa Pendergast: The COVID-19 pandemic is a much different event than the Great Recession. The 2008 financial crisis revealed severe weaknesses in the financial system and underlying infrastructure. Most significantly, key financial institutions were inadequately capitalized, creating an environment that was rife for the financial collapses experienced across financial institutions. Many blame the housing bubble and the residential mortgage market for the collapse back then, and it certainly holds much of the culpability, but that is an overly simplified explanation. The 2008 financial crisis quickly uncovered a financial system that was overleveraged, undercapitalized and inextricably over-connected, exposing a financial system that was more vulnerable to collapse than most believed. It was a long road back. To the good, regulators have spent the last decade building up banks’ resilience through more robust, sturdier capital and liquidity buffers.
The pandemic, however, is a very different animal—an external shock unrelated to the strength of the markets. Regrettably, many entities won’t survive the fallout of the pandemic, resulting in forced asset sales of all kinds. Yet, as noted above, markets entered this historic time with far more stringent risk-based capital, liquidity and risk retention requirements; we’re a lot more resiilient in that regard for sure. We expect that many organizations should be able to weather this liquidity crisis. However, if the current state of the market morphs from a liquidity to credit crisis, the outlook is far less sanguine for financial markets and the U.S. economy.
NREI: Right now the impacts of the crisis are playing out in extremes, hitting some property types incredibly hard (hotel, office) and others more mildly (industrial, self-storage). What will this ultimately mean for the CMBS market?
Lisa Pendergast: The pandemic has brought with it a significant amount of uncertainty—ultimately, we don’t know where the dust will settle. What we know now is that the CMBS market is far better positioned today than it was in 2008. The underlying loans are underwritten with conservatism, with average loan-to-value ratios ranging from 55 percent to 65 percent on in-place cash flows. And just as importantly, CMBS are privy to heightened credit protections, particularly the structural credit enhancement required by the rating agencies.
Undoubtedly, some property types, due to the nature of the pandemic and need for social distancing, will be negatively affected more than others. Many commercial properties, such as malls and hotels, have been required to shutter their doors. For retail, that means that tenants will find it difficult to pay rents; and remember, the going has been rough for a number of years now in the retail sector. For hotels, shelter-in-place requirements have caused most hotels to close and those that are open tend to cater to pandemic relief personnel—even then, occupancy rates are in the single digits in many cases. As this dynamic unfolds, the CMBS marketplace has grown increasingly concerned about our property owner/borrower community.
NREI: One tactic I remember from the last time from lenders was “amend, pretend and extend” for loans, to give borrowers additional time to try and recover and to help spread the pain, so mountains of real estate debt weren’t going bad all at once. Do you think we could see a return of that tactic?
Lisa Pendergast: The Great Recession, stemming from significant banking and market vulnerabilities, was a drawn-out affair. The pandemic, on the other hand, has hit quickly and forcefully. In many ways, I liken the current environment to a natural disaster, such as a hurricane, and the immediate and direct impact such an event has on hard assets like commercial real estate. Think about Hurricanes Katrina and Sandy; back then all lenders experienced a massive influx of troubled commercial and multifamily loans, but both were ring-fenced, geographic events. Unfortunately, today, loan servicers are seeing that again, but this time across the U.S. and really across the globe. Just as important, the key difference this time around is that the damage isn’t due to wind and rain and thus to physical structures, but a pandemic that is preventing owners of commercial real estate and their tenants from opening their doors. The uncertainty is rampant, forcing owners and servicers to fashion forbearance agreements without really knowing just how long this will continue and whether even if the pandemic subsides it would return this fall or winter. With that in mind, the real concern is whether the current liquidity crisis becomes a credit crisis, with tenants no longer able to operate longer term and property owners struggling to make mortgage payments.
NREI: The Fed moved very quickly this time, in part because it had the experience of 2008/2009 under its belt and a sense of what tactics worked and what didn’t. Do you think that decisiveness and the quick move to revive many of those older programs will impact how the distressed cycle plays out this time? Has there been any indication of TALF being extended to private-label CMBS?
Lisa Pendergast: The markets welcomed the Federal Reserve’s quick and decisive action to stand up TALF 2.0. TALF 1.0 played an important role in reviving liquidity during the financial crisis and the addition of CMBS to the TALF program has an immediate and game-changing impact on the sector. The market expects TALF 2.0 to have similar success, but additional, critically important CMBS structures must also be included. In short, this is a great first step, but we’re going to continue to push for the inclusion of new-issue CMBS, as well as single-asset single-borrower (SASB) CMBS and commercial real estate collateralized loan obligations (CRE CLOs) into the program. The commercial real estate debt market plays too critical a role in the overall U.S. economy and will play an even more critical role in the recovery from the coronavirus. Regulators have shown already that they recognize that and we are hopeful that these other funding markets will be included into TALF 2.0 in short order.
NREI: In the last cycle, the CMBS sector was quite a bit larger than it is now. Conduit loans had higher rates of delinquency and defaults than other lender types. With less of that kind of debt out there, what does that mean for this cycle?
Lisa Pendergast: We would like to highlight the significant increase in diversity within commercial real estate lending. There is now generally more competition for CRE loans than in 2008. Mortgage REITs, debt funds, etc. now all compete for the same business, but CMBS still remains a critical and wide-ranging source of funding—while conduit CMBS tend to focus on smaller loans in secondary and tertiary markets, the SASB market addresses those large institutional-quality loans above $500 million that tend to be underserved by other lenders.
Back in 2008, conduit CMBS represented 50 percent of the CMBS market. Since then, SASB CMBS have grown in stature and now represent almost 50 percent of all CMBS lending. SASB CMBS are conservatively are conservatively underwritten, possess very high levels of transparency, and are privy to significant structural enhancement beyond the credit worthiness of the asset and loan itself.
One other CMBS-related asset class we would like to see added to TALF is CRE CLOs. These too are conservatively underwritten, with significant credit enhancement at the structural level. The CRE CLO market is unique to the current pandemic in that it will play an important role in the recovery. The CRE CLO lender community fills a valuable need for transitional commercial and multifamily real estate and will be critically important for commercial and multifamily properties emerging from the pandemic and needing financing to get their assets back up and running.
NREI: Are some of the structural changes put in place in the CMBS market after the financial crisis having their desired impact right now in a time of stress?
Lisa Pendergast: Following the 2008 financial crisis, markets and financial institutions implemented significant reforms as a result of Dodd-Frank and Basel requirements. Key among these reforms were enhancing capital and liquidity requirements, including stringent risk-based capital requirements and liquidity coverage ratios. We are noting greater resiliency, therefore, within the financial system, which should allow many to weather this storm. Additionally, more robust investor reporting requirements (like Reg AB II) and transparency have allowed market participants to understand developments in real time. While there will be some market players who will not survive this crisis, we believe that a significant swath will pull through. Of course, our assessment may change if the liquidity crisis turns into a credit crisis.
NREI: Another potential difference this time is that CRE fundamentals themselves were extremely strong and most sectors didn’t seem to be looking at overdevelopment or some issues like that. What will that mean for this cycle? Ultimately, CRE fundamentals are contingent on the broader economy and whether there are the tenants to fill the space, but does the position of the CRE sector itself going into this potentially mitigate some of the issues that could emerge?
Lisa Pendergast: Indeed, supply has been maintained at manageable levels—no overdevelopment compared to 2008. However, how that plays out remains to be seen. We just don’t know how long this pandemic will last (or how many phases/waves we will see).