How is COVID-19 Going to Affect CMBS Delinquency Rates?
By Adam Gower Ph.D.
This article is based on a podcast conversation I had with Pete Larsen, Attorney at Leger, Ketchum and Cohoon.
With good reason, many commercial real estate industry professionals are monitoring the COVID-19 crisis closely. There has been a lot of chatter as to how the virus will impact the future of commercial real estate – from lending to new construction, from interior design to leasing – and everything in between. There’s no doubt that concern over viruses will certainly play a role in the industry’s long-term thinking.
In the more immediate term, all eyes are on rent payments. Business closures have been widespread and more than 26 million Americans are now unemployed. The federal government’s CARES Act, a stimulus package worth hundreds of billions of dollars (and growing), has provided some relief. How long these benefits relative to how soon the economy reopens remains to be seen. Even best-case scenarios reflect some negative impact on rent payments over time.
Today, we look specifically at how the COVID-19 crisis is going to affect CMBS delinquency rates. CMBS securities were ravaged during the last downturn. Should we expect the same today? Read on to learn more.
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What are Commercial Mortgage-Backed Securities?
High street banks will originate loans and then sell them on to an investment bank who in turn packages them in with other banks’ originated loans to create a security – a commercial mortgage backed security or CMBS – that is sold on the open markets like a stock. In these cases, the borrower starts with a bank they are familiar with and only later are their loans packaged and sold into a CMBS.
CMBS are also sometimes structured as a form of conduit loan that is often utilized to purchase commercial real estate where the borrower knows that the ultimate destination for their debt is going to be CMBS. CMBS loans are generally packaged and pooled by investment banks and other conduit lenders and sold to the public.
What is a Servicer and a Special Servicer?
When a loan is pooled into a CMBS it ceases to be serviced by the originating bank. Servicing is the process of billing the borrower, keeping tabs on the principal balance due, payment due dates, insurance requirements and other basic loan terms and conditions. It is the function that describes how a loan is, well, serviced during its life cycle. Once the loan has moved into the CMBS pool and the originating bank stops servicing the loan, another entity takes over appropriately called a ‘servicer.’
Servicers have little authority over a loan because their primary role is simply to administrate a loan. Once a loan goes into default however, and because servicers have not discretionary authority, the loan is passed on to a ‘special’ servicer who does have authority to enter into discussions with a borrower to resolve any payment issues.
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What Kinds of Loans are in a CMBS Pool?
CMBS loans can be used for all income-producing property, not just multifamily as is the case with similarly structured agency loans. Loans originated from local banks that end up in CMBS pools or that are originated specifically to be CMBS, are often collateralized by office buildings, retail properties, industrial buildings, hotels and self-storage facilities. While not specifically designed for multifamily lending, CMBS loans can also be used by multifamily borrowers (though they’ll typically find that agency loans provide better rates or terms).
CMBS loans are generally long-term loans on properties with stable cash flows making them relatively “safe” from an investment perspective and do not require an active lender. This is one of the reasons why CMBS securities appeal to institutional investors, who tend to be relatively risk-adverse.
How Commercial Mortgage-Backed Securities Work
Let’s take this in two parts: first, let’s look at how CMBS loans work. Then we’ll dive into how CMBS loans, once sold as securities, work when actually being traded on the stock market.
CMBS loans are originated as traditional loans. Where they begin to differ is how they are structured, in this case, through a conduit. The loans are then packaged and sold to the public as bonds. Wall Street investors are the primary purchaser of CMBS securities. Most of these loans have a fixed interest rate and are amortized over a 25 to 30-year period. On occasion, CMBS loans will amortize over ten years with a balloon payment due upon maturity.
There are two basic underwriting parameters that govern most CMBS lending: the loan-to-value ratio (LTV) and the debt service coverage ratio (DSCR). DSCR is the ratio of the total operating income to the total cost of servicing (paying) the debt. Each lender will evaluate LTV and DSCR differently based on the borrower’s credentials and risk associated with the specific deal in question. For example, most CMBS lenders would consider a stabilized office property to be less risky than a land development deal. The lower the risk, the more a lender might be willing to lend, and therefore, the higher the LTV.
CMBS loans are typically non-recourse loans with basic “bad boy” carve-outs. When a loan is said to be “non-recourse,” it implies that a borrower is not personally accountable for the repayment of the loan i.e., they do not need to make a personal guarantee as a condition of the loan – a huge advantage to borrowers.
Now, as it pertains to how CMBS securities work once on the market, they function much like other stocks do. Let’s say you buy a CMBS security for $100 that has a 5% coupon. As the value of the securities goes up or down, the yield on that coupon goes up or down accordingly.
CMBS pools are governed by real estate mortgage investment conduit (REMIC) regulations which are founded in the tax code. REMICs are special purpose vehicles (entities) that are used to pool loans into a CMBS. They are granted tax-exempt status under certain conditions that allow for tax consequences to pass straight through to the individual investors.
If the individual loans within a CMBS portfolio begin to default, if they’re not creating the income that was anticipated through the life of this CMBS vehicle or require substantial modifications, the REMIC status could be eroded which could mean the issue may lose its tax exempt status preventing it from selling any more of its securities. This is why loan performance is so critically important to CMBS portfolios.
Investors may recall that CMBS securities took a beating during the last economic downturn. This is because CMBS vehicles included loans of all kinds—good and bad. Non-performing loans that otherwise should have been sent back to the loan originator were instead included in the portfolios, dragging down the performance of otherwise AAA-rated loans. Bad loans were sometimes removed and included in a follow-on CMBS loan portfolio, and this led to the consolidation of underperforming loans in CMBS packages that eventually went belly-up.
CMBS lending rebounded coming out of the Great Recession, though the problems that emerged during the last downturn (which have since arguably been improved) has certainly caused some people to shy away from investing in CMBS securities.
Trepp CMBS Delinquency Rate Trend Going into 2020
For nearly three years, CMBS delinquency rates had been on a downward trend. CMBS delinquencies totaled 5.8% in June 2017 – well below the peak, which hit 10.3% in July 2012. CMBS delinquencies have continued to fall in 27 of the past 33 months and were hovering around just +/- 2%.
According to the Trepp CMBS Delinquency Rate, which monitors ongoing CMBS activity, there was a marginal uptick in CMBS delinquencies in March, up just 3 basis points month-over-month. Slight upticks such as these are not uncommon. Indeed, the Trepp CMBS delinquency rate increased at a significantly higher rate between May and June 2019 than it did between February and March 2020 indicating that, on the whole, CMBS delinquencies were trending downward heading into 2020.
How Will COVID-19 Affect CMBS Delinquency Rates?
It is still too early to tell how CMBS will impact delinquency rates. How widespread loan defaults will be remains to be seen and will certainly vary depending on asset class. That said, experts generally agree the CMBS delinquency rate will tick up to some degree. The biggest impacts will be felt in the retail and hotel sectors, so the extent to which CMBS portfolios have an oversized share of these loans, there could be an uptick in delinquencies.
CMBS special servicers will be busy during this time. We expect the special servicers to be working closely with affected borrowers to provide some period of forbearance or other work outs to get through the current economic shutdown.
In terms of timing, it will likely take several months to see any COVID-caused swing in CMBS delinquency rates. Most tenants continued to pay rent in March. April collections weakened but overall remained strong. Many borrowers drew down their lines of credit in full as a way to have cash on hand if need be, so that is providing a buffer for some. It may not be until May or even June and July until we see how COVID-19 will truly impact CMBS delinquency rates.
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March 2020 Not Affected by Coronavirus
As noted above, the CMBS delinquency rate increased slightly between February and March 2020. The March increase brought the delinquency rate to 2.1% which is still near historic lows and was more of a blip on the radar than anything else.
Despite the increase, it is unlikely that this increase had anything to do with COVID at all because most borrowers make their loan payments on the first of each month and the industry had not yet experienced the widespread impacts of COVID as of March 1st. It will be more important to monitor what happens to delinquency rates in May and June as loans reach 60- and 90 day delinquencies at which point they become classified irrevocably as non-performing loans.
To avoid this from happening, many borrowers have drawn on lines of credit to stay afloat. Others have or will be getting support from the federal government’s CARES Act e.g., the Payment Protection Program, which is intended to help businesses pay both staff and rent – the benefits of which will flow through to landlords.
Rising Landlord Defaults Going Forward
There’s a big difference between how loans were made leading up to the 2008-2010 downturn and today, a difference that should (in theory) result in fewer landlord defaults. Back then, lenders were making loans that they had no business making – either they had no knowledge about the product type, or the geography, or they weren’t doing their due diligence on borrowers. Community banks were making loans better suited for large institutional lenders without really knowing what they were getting into.
There were all sorts of problems that contributed to a spike in CMBS loan defaults. Regulators reigned in this “Wild West” mentality during the recovery, ensuring lenders made more appropriately scaled loans that were carefully underwritten and suitably guaranteed. This should result in fewer landlord defaults as a result of the COVID-19 crisis. Defaults will largely depend on the asset class, with some property types more susceptible to COVID shutdowns (e.g., retail and hospitality) than others.
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Hotels Most Vulnerable Right Now
The hospitality industry is the most vulnerable to default right now. Travel and tourism has essentially been shut down, both domestically and internationally. Even states that have begun to reopen continue to restrict travel and hotel stays by, for example, requiring out-of-state visitors to quarantine for 14 days upon entry. Many hotels are running at 10% occupancy or less and some have closed up shop altogether.
Hotels will certainly influence CMBS portfolios, depending on the loan mix within those CMBS vehicles. CMBS portfolios can have anywhere from a handful of loans to upwards of a thousand loans, though most have closer to 50 or 100. Portfolios cannot be split up. In other words, a conduit cannot peel off the underperforming hotel loans to protect the portfolio as a whole. Therefore, any CMBS issuance with an oversized share of hotel loans could be in danger of default.
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CMBS Servicers May Give a Break to Borrowers with Maturing Loan
One of the biggest knocks on CMBS loans is that once the loan is sold through a conduit, the loans are managed by a CMBS servicer. The servicer doesn’t have much authority to do anything other than collect money and account for it. If the borrower is facing default, the servicer must send the loan to a special servicer who can review and see whether relief is warranted. This is a time-consuming process, particularly when default is imminent. Often times, a loan will not be sent to a special servicer until after the borrower has actually defaulted. This creates a difficult catch-22: the borrower doesn’t want to default, but in order to talk to a special service, they must default. This is much different than having a traditional loan that is held by a bank, in which case you can call your loan originator to discuss your options prior to default.
Despite this conundrum, we expect to see special servicers to be active once loans are in default. The special servicer has an obligation to the protect portfolio and ensure that performance won’t result in REMIC status being terminated. This will require special servicers to work closely with borrowers, whether that’s forbearance, modification, refinancing out of the portfolio (and into a traditional loan) or some other resolution. Otherwise, widespread defaults could result in losing REMIC status, which would prohibit the conduit from publicly trading securities moving forward.
That doesn’t mean that investors are insulated. Even special servicers who successfully maintain the REMIC status could have loans that default and investors will lose money. However, we anticipate that special servicers will go to great lengths to mitigate losses for investors in order to protect that REMIC status.
So, what should investors make of all this?
In short, we anticipate that there will be some discounted CMBS note sales that happen moving forward. To what extent that’s the case, we still don’t know. There are still some “bad” borrowers out there who have been riding this latest wave of real estate. These borrowers may have poorly executed business plans, with deferred maintenance and ill performed underwriting, that could make it more likely that they end up in default. These are the borrowers who will have a harder time convincing CMBS servicers that there’s a way out on the other side of this downturn, so CMBS servicers will be less likely to find a workout solution on these loans.
The good news, though, is that the systemic CMBS sell-off that we witnessed during the Great Recession is unlikely to occur this time around. There will be spot sales, but given the strong underlying market conditions, most well prepared borrowers should be able to ride out this storm with a bit of support from their CMBS lenders.
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