My guest today, Linda Pendergast, was the president and former member of CREFC's board of governors for over nine years. She previously served on the editorial board of the CRE finance world at CREFC. She's been a top ranked research analyst in the highly competitive institutional investor, All American Fixed Income Research Team Survey in the CMBS category. She is a published author of multiple articles and reports on various aspects of CMBS. She was managing director and head of CMBS strategy at Jefferies and prior to that was managing director in the Fixed Income Strategies Group at the Royal Bank of Scotland.
To put it mildly, Lisa knows her stuff. In this episode, Lisa explains what to watch for in terms of who will prove to be the winners and losers in commercial real estate during this pandemic, who is likely to emerge stronger and who is likely to emerge weaker. Learn also how Lisa works with legislators to advocate for the commercial real estate industry and what that means to you, as well as what macroeconomic trends to watch for as you look for investment opportunities in the months to come.
What You're Going to Learn
Who Are the Real Estate Classes Have and Have-Nots Post Covid?
How Much Capital Injection Does Commercial Real Estate Need to Avoid Collapse?
Exploring A Program Designed to Address the Liquidity Crisis Caused by Covid
The Difficulties Underwriting Commercial Real Estate during Covid
How Real Estate Underwriting and Pricing Are Impacted by Covid
Exploring Policy Changes and Advocacy for the Commercial Real Estate Industry
How Where People Choose to Live and Work Affects Commercial Real Estate
Where Would You Invest in Commercial Real Estate with $1 Million?
How Commercial Real Estate Communications Has Adapted Since Covid
ADAM GOWER: Lisa, what a pleasure. Thank you so very much for joining me on my podcast.
LISA PENDERGAST: Thank you for the invitation. Appreciate it. Looking forward to the conversation.
ADAM GOWER: In our pre-start chat, you mentioned a few things and I just have to go for the big highlight to start with. I'm dying to know. You talked about the world being a world of have and have-nots. Why don't we just start right there. Who are the haves and who are the have-nots? And what's going on in the world?
LISA PENDERGAST: Thanks for asking that question because it sets the table for the rest of our discussion, I think. When I say haves/have-nots, I really mean who's involved in terms of asset classes where you can, sort of, see the daylight and in some cases maybe even benefiting from an environment in which we've all learned to live, which is amidst COVID. And then there are those that are being completely devastated as a result of COVID. So the folks, the so-called "haves" are those such as industrial, where the e-commerce and the like, have certainly been driven to new heights amidst COVID and the beneficiaries are the industrial properties out there that are benefiting. Same thing, I think to some extent, offices, because of long-term leases, currently are performing and I'm looking at this, first and foremost, from a loan performance perspective, which in my mind is very reflective of what's going on at the asset level. So, to the extent that multifamily, industrial, office, all have delinquency rates in the CMBS market and I use the CMBS market because it is one of the most transparent commercial real estate lending markets. So you'll get monthly data. That's not to say that you cannot get some level of data on the banks at live companies, but that tends to be quarterly and it is far less granular than what you'll get in the CMBS market. So we use CMBS as an example. But in that world, it's 3% or less.
LISA PENDERGAST: However, when you go to a more operating business like a hotel, many of which aren't operating, were closed for a significant periods of time. If they are now open, they're still working with a delinquency rate in a single digit, generally, number. So, you have delinquency rates in hotel right now of about 23% and you have retail delinquency rates of about 15. Those are the "have-nots" in terms of just their well-being amidst COVID. And while I do think that some of these things will grow to be better, what we know in retail is that the distress in the retail market has persisted for quite some time. So, unfortunately, for some of those retail assets, COVID is the thing that's going to push them over the edge. It either means change in ownership at some point or the complete demise of the asset itself, where an alternative use is now what you're looking for as opposed to a retail location.
Commercial Real Estate Needs Injections of Capital to Avoid Collapse
ADAM GOWER: It's interesting you say this because what you were describing was the evolution of Kmart into Target, which is really just a different kind of retail. What I actually remember. I hate to think of it. It was probably around 25 years ago, I was running a division of National Amusements, Sumner Redstone's Company, actually, in Asia-Pacific and one of their premium brands was Blockbuster Video and we realized even then, that that was going to become obsolete. That technology was going to make video rentals completely obsolete. There was no replacement. It wasn't Target for Kmart. It was empty space for something completely different and that's really what we're seeing now, isn't it, Lisa? I means is this acceleration of trends, especially in retailing that, what are you seeing in terms of a complete change in use across the retail landscape, like adaptive reuse from what was retail to not retail now?
LISA PENDERGAST: Unfortunately, when you ask that question, the one thing, it comes to mind is, you see these blighted areas and certainly, certain malls it depends. Your B, C-Class malls that are out there, have become, just wastelands that there isn't a replacement, in many cases, depending on the location, depending on what sprung-up, around that particular location. And frankly, when we talk about, to regulators and legislators today, about why we think commercial real estate needs injections of capital and help for borrowers to, kind of, bridge that gap, bridge the COVID gap, If you will. The thing we talk about is: do you really want to see these blighted areas across the country because no one could afford to carry that property for any longer during COVID? And, in many cases, what you find is, there's no replacement, especially for these larger, sort of either, community shopping centers that are bigger than a community shopping center, they're a little bit bigger. Who do you put in there to replace those tenants and can you replace those tenants sufficiently such that you can generate cash flow to pay your debt service on your loan?
A Program Designed to Address the Liquidity Crisis Caused by Covid
ADAM GOWER: You mentioned talking to legislators. That's something that you do, isn't it? Tell me something about that. So what's your role in that? It's very interesting.
LISA PENDERGAST: CREFC represents all of the lending and debt investing community. So we represent CMBS lenders like company lenders, bank lenders, these new crops of debt funds that have come up since the great financial crisis, previous crisis, as well as all the debt investors. So, the CMBS bond buyers, the loan buyers, the MEZZ buyers, those types of folks. So, we have been advocating on a number of fronts. The first real advocacy effort on our part was to try to get the CMBS market, in pricing, sort of, back in line. When COVID hit, everyone knew it was going to hit hard assets like commercial real estate. One of the most hardest hit, I would argue, and then that would effect the prices on the bonds. So we saw, for example, you know, on our benchmark bond, which is a 10-year triple-A bond that has got 30% credit enhancement, a very strong, safe triple-A security. But spreads on that bond went from about 90 basis points over the 10-year swap rate to about 340, almost within a week or two and that's important because that's a big component of the security. However, we saw down the capital stack, triple-B, triple B minus bonds really get hit such that you went from a $90-$100 price point to something in the 60s and 70s, dollars now, not basis points.
LISA PENDERGAST: So you lost tens of points on these bonds. What we did was we worked with the Fed who re-instituted TALF, the Term Asset-Backed-Securities Loan facility.
ADAM GOWER: I remember that.
LISA PENDERGAST: This is TALF. This is different. This was for bonds and basically what it does is provide investors with a bit of leverage so that you can buy these securities and you can almost assure yourself of having a reasonable return, assuming that you have faith that that 10-year triple-A bond is going to survive and all of them did in the last crisis. So, to the extent that it was important to us to get that, sort of, sponsorship for the CMBS market. And to the good, on April 9th, we were able to get working with the Fed, who once again took out TALF, which was a, sort of, part of their playbook from the previous crisis and reapply it to the current crisis. CMBS was one of the last asset classes to actually become eligible for the TALF program and to the extent that it really did cause our spreads to go somewhere around 350 basis points on 10-year triple-A's to back to toward today, where there were about a 100 points off, which is kind of where they were prior to the crisis.
ADAM GOWER: So how did the TALF work? I'm sorry, I don't.
LISA PENDERGAST: It is just a mechanism and I don't want to get too deep into it because...
ADAM GOWER: But it was a back stop, basically a back stop?
LISA PENDERGAST: It is a mechanism that provides leverage to those investors who wish to buy the bonds with the idea of enticing people to be more involved in the sector, to feel comfortable that they have some leverage in terms of their return regardless if this were to go down further. Really, it's to stem losses on these bonds, ultimately, and I don't mean realized losses, I mean mark-to-market losses.
ADAM GOWER: OK, alright.
LISA PENDERGAST: We're quite comfortable on a 10-year triple-A super senior bond that has 30% credit enhancement. You are not going to take a credit loss on that bond. But if you bought the bond at par, one hundred cents on a dollar and all of a sudden it's trading 70 cents on the dollar, then you have a mark-to-market, you have a pricing loss. And so, the whole idea is to get people back, comfortable to buy these bonds and it gives them a little bit of leverage such that your returns are leveraged, if you will. And so, it brings people into the market and it quickly corrected the triple-As to a point where they are, quite, you know, kind of, back to where they were. What's not, as I said, is down the credit stack in the triple-B minus bonds where, you may take a loss, if losses continue to behave and, or I shouldn't say "losses", but actual loan performance continues to be as difficult as it is right now.
ADAM GOWER: So it keeps liquidity in the market, basically.
LISA PENDERGAST: No question. You said it faster and better than I did.
Difficulties Underwriting Commercial Real Estate during Covid
ADAM GOWER: But what I have been hearing, though, is that it has still been difficult to get credit, so talk to me about that and why, what is going on that makes it so difficult to underwrite commercial real estate, at the moment, particularly on the lending side?
LISA PENDERGAST: Sure.
ADAM GOWER: I think the most significant thing is the uncertainty. I think we've gotten past the point, very early on in the crisis where, it was really difficult even to get to an asset to appraise valuations on assets. I think that's getting better the more we open the country to commerce. And so, to the extent that the uncertainty comes with, if you were 95% occupied as, say, you know, a retail property, prior to COVID and you're currently 50% occupied, what's the likelihood of you returning back to that 95% at some point in the future and hopefully the near future. Or, is this something that somehow is going to impact. I think the concern always is, it's not just the real estate, it is: what does the country look like from a growth perspective and the economy look like from a growth perspective several quarters from now, two years from now? Are we going to be in this, sort of, double dip where you have this immediate impact of COVID that causes stoppage and occupancy rates to plummet to an environment where that might start to get better, and yet you're in an economic downturn and a recession that could last for several years. And so, how do you underwrite to something like that? And it does suggest that you're going to stick to and gravitate toward the asset classes that are more, sort of, stable. So industrial, for example. I think there are a lot of folks who are looking for industrial properties. Their outlook is good regardless of the economy. You still need to buy things from Amazon and Amazon needs to ship them from somewhere. Right? And they need that industrial, you know, just outside of a city, kind of an asset. And so, I think that there is going to be continued food fights for good industrial. Office is a very different thing, though, because that goes back to two things. One, do more people just continue to work from home and they decide they need less space? Or two, that they're just not comfortable coming into a city using public transportation to get there. New York City subways. What's that going to look like? You're protected currently by long term leases in place for the office market. But when those leases start to burn off, the real question is, do you go back? And if you do go back, do you want the same square footage? Do you want to reduce your, sort of, platform such that you can have half your workforce come in, you know, half the week and the other, the other.
LISA PENDERGAST: So it's, to me, it's the uncertainty in underwriting right now, in terms of where rents are going, what the occupancy level is going to look like, what's it going to cost to retrofit that space to be COVID-friendly, you know, and to be able to fight the virus and you have your employees feel safe in that office space? It's almost that I'm sure folks are doing it. As an analyst, I think what you would always do is try to look at any given MSA, what's the square footage or the lease burn-off look like in a lot of these office properties? Because when that happens, there is going to be a reset and it's probably going to be a reset to lower rents. Depends where you are. If you're in an urban area, probably reset to lower. If you're in suburban area, it's probably going to be reset higher. You know, there was a period coming off the great financial crisis where, you know, suburban office was "Death Valley". It was really difficult to figure out where you were going to go, in terms of, getting that occupancy rate up in those suburban markets. Now, it's quite the opposite.
Real Estate Underwriting and Pricing Impacted by Covid
ADAM GOWER: Well, that's right, if you wait long enough, that's kind of where I was headed, is that, when we get back to normality, will it look the same as it did before? And the way that lenders underwrite is by looking at past performance, right, you look at what happened. You try not to predict, but you base it on what happened before. What's difficult now is that what happened before may not actually look the same going forward. It's going to morph. It's going to change.
LISA PENDERGAST: That's correct. I mean the forward looking, you know, the smart underwriters out there are going to try to bake in as much exactness as they can into what rents and occupancy is going to look like, and demand. And yet, a lot of it's going to be guesswork. And then, the other side of it is, at the end of the day, you are going to underwrite more conservatively on a go forward basis, given my concerns also, that you will be in a recession. Right? That, just an economic perspective, the medical, you know, sort of, emergency goes away, but an economic one is here to stay for 24 to 36 months. And then, how do you underwrite that loan? And what it does suggest, at the end of the day, for property owners or want-to-be property owners, is that your leverage points are definitely going to be far more conservative than they ever have been, from a credit perspective. And even in the CMBS market, I think our lenders will feel that way. They're going to want to be more conservative, more reserved. As a borrower, there's going to be more upfront money that you're going to have to put in because you just don't know what the world's going to look like and it means you're going to get less proceeds on a loan, which ultimately means that asset valuations and where you bid on an asset, if you're looking to buy, is going to bake all of that in, which suggests lower property prices as we move forward.
Policy Change and Advocacy for the Commercial Real Estate Industry
ADAM GOWER: You work at a very, very high level in the stratosphere of policy in this industry, right, so it's not something that most people are witness to. So tell me, what inputs do you use to establish the kind of policy recommendations that you do? I know that you mentioned some data that you have, so I'm interested in not only what the data is, but where it comes from and how you use it to formulate recommendations at the policy level.
LISA PENDERGAST: Sure. One of the things is, you need to set the table and explain how commercial real estate is important, not just to our world, but to the environment, to the US, to various cities. You know, one of the things that doesn't always come up is that, when you look at commercial real estate assets and the cash flow they throw off, you know, that's about 18% of GDP. And, it's not a number that people would equate commercial real estate with. In addition to that, if you think about where people work, where are the employees? They are in commercial real estate of all sorts. So we house a significant number of employees and without those houses, you know, in good standing, it does suggest that your employment rate, you know, is going to fall. So, to the extent that right now, you see all of these large malls closing. You know, that's a lot of jobs. Same thing with hotels and a lot of these folks, particularly in the hotel industry, you know, it's a fairly low wage environment and yet they count on those wages to survive, to feed their children, to house themselves. So, to the extent that it's meaningful and that's something we've tried to get across and what we've found is that while well-intentioned, many of the programs that have been stood up by the government really do not include commercial real estate. I've stopped asking myself to explain why, because I don't know why. It seems like there is a good reason that..
ADAM GOWER: Is it because it's politically unsavory? I mean this idea that real estate developers owners are the wealthy and so why should we be, you know, padding their pockets and not putting it somewhere else?
LISA PENDERGAST: You didn't hear that from me, but I suspect that there's a little of that concern and I don't necessarily blame them, right? I mean you need to be careful to make sure that those who can, do, right, and that you're helping those who can't. And yet arguably, the ones we want to represent, are those...we want to represent all of our borrowers for sure and we've worked with all the borrower trade associations very closely to bring that message that, this is a sector that seems to have been ignored by the federal government. And so, we've not necessarily seen help from the CARES Act. The programs that have been stood up like PPP, the Paycheck Protection Program, Main Street Lending program. Both of those programs do not allow for passive real estate to be involved. So we're excluded from those programs. We've tried to put forth, and have had some wonderful help, from Congress, from the Senate, from the House, in terms of recognizing the need. Recognizing that we're not necessarily standing up for the public companies out there, say the big public REITs that can go to the capital markets to raise funds, right? And we'd like to help them all, but, one would argue that the guy who owns three Marriott Courtyards somewhere in the Midwest, that's not a guy that can tap the capital markets to get assistance.
LISA PENDERGAST: And so we're really looking to try to help that particular borrower and I'd say, to the good. You know, there's been a lot of talk about loan forbearance and what we've learned is that, the word forbearance means many things to many people. My view of forbearance is, whatever I do as a lender to allow for some leniency in getting you through this period of COVID is a form of forbearance. So, we either say, you know, we're going to postpone you having to make your payments for the next six months with the goal being, when that happens, you start paying rent and those six months that you didn't pay get tacked on to the back end of your mortgage. Or, we've forced you to put aside a lot of reserves for, you know, PIPs, for any kind of improvement plan that you have, go forward that, you know, maybe your hotel requires that you put into your property, say. Let's repurpose those reserves, whatever they might be, to pay your mortgage and then we'll worry about replenishing those reserves when everything's, sort of, semi back to normal. And so, there are ways to forbear and I think within both the CMBS market, with the banks and the life companies, and to the good, the banks and the life companies got some regulatory relief on this issue from troubled debt restructurings which normally would have required that you hold a significant amount of capital against those. They've been, kind of, given some relief in that regard. So, there has been some help and as I said, TALF is important not because of just what it does for the capital markets, but the way in which you quote a CMBS loan is significantly based on the pricing of those CMBS bonds. If those bonds price low, yields go up, means your mortgage rates go higher, so, the ability to continue to lend at a rate that is palatable to our borrowers was really determined by TALF and its ability to tighten spreads to increase CMBS bond prices to a level where mortgage rates could be quoted from the CMBS market that were palatable to our borrowers and you know, the fact that the Fed has done a great job lowering interest rates and that certainly has helped mortgage rates across, you know, the country and across asset classes to fall.
Where People Choose to Live and Work Affecting Commercial Real Estate
ADAM GOWER: Do you look at residential real estate as an indicator of how commercial real estate will adapt? Like is that something that you take into account?
LISA PENDERGAST: From an asset class perspective, yes. So, when we talk about how residential, people who owned apartments in Manhattan moving out to all of the various suburbs of the city, you know, clearly then you say a lot of those folks don't also want to commute into Manhattan. So therefore, the suburban office property that's three and a half miles from your new home, is a perfect place, right? And if you are fortunate enough to be the owner of that business, then you're likely to say, I'm going to move three and a half miles away from my home. I will save my employees from having to take public transportation at a time where... and that's the difficulty. The uncertainty goes back to COVID. Even if, you know, we're sure, we will all, the world will be gifted with a vaccine of some sort. But I suspect it's going to take some time for a comfort level, for a safety level and for everyone to be immunized. So, you know, it could be some time before anyone says, hmm, you know, the property values in Manhattan look pretty attractive or rents have fallen dramatically. I'm a young person or a young couple. Let's move back into Manhattan. But that's not going to happen overnight if you've just made the big move outside of the city and you may never come back.
ADAM GOWER: You know what, as well, we moved from a major city about six years ago, completely unrelated to anything other than whatever was going on at the time in my life. And first of all, I'm very happy that we did. We live in an agricultural location and here I am talking to you. I don't even know where you are, it could be anywhere. I presume you're on the east coast of New York somewhere, right? It doesn't really matter. But once people make that move, you would never think to do it, but once you do make that move and realize actually, that life is better, right, it really makes it difficult to even imagine going back into the center of a massive conurbation. Like, why would you do that? It took me a long time. I came kicking and screaming you know I've lived in big cities all my life, but my wife wanted to move. So we moved here and now I cannot imagine living in a big city. If this goes on long enough and if people do actively migrate, right, and aren't just locked down, that movement back really could have a generational shift in commercial real estate.
Where Would You Invest in Commercial Real Estate with $1 Million?
ADAM GOWER: So my question is, if you had a million dollars. It's an unfair question a little bit, spare, hanging around somewhere, where would you invest it? With all this uncertainty, but with all the knowledge that you have in policy and what's going in the industry, what would you be investing your money in? And it better be CRE of some sort.
LISA PENDERGAST: I was just going to say....
ADAM GOWER: Don't tell me gold!
LISA PENDERGAST: If I want to keep my day job, it has to be in commercial real estate somewhere. I think if I could find, on the cheap, an industrial property, I'd buy one. Hands down. And/or a suburban office, right, which you can find probably, in a much better entry point than I might find that industrial property.
ADAM GOWER: Very interesting. And you know something. I actually think that co-working is going to become significantly stronger because although WeWork has had its troubles and is the most visible, the fact is, it's an incredibly comfortable way to work. To go into a space where you are surrounded by other workers, even if they're not your colleagues. And so, if you are somewhere remote, right? You're not in the middle of a city going to a head office, but if you're in a suburban area, I could work for CREFC from here but I don't want to sit in my house all the time. If I go to a local co-working spot, I can be there with all the benefits, in fact, even nicer than a normal office.
LISA PENDERGAST: Right.
ADAM GOWER: Right? And still be working anywhere.
LISA PENDERGAST: That's true. You'd have to question, though, at what point do the remnants of COVID, or any kind of pandemic, sort of, has it stifled the desire for co-working space? Do you want your own space that you keep clean, that, you know, maybe the cleaning folks come in, in the evening, and they clean your space? I'm, kind of, you know, of that ilk where I probably would come in with my own bottle of something.
ADAM GOWER: I can see the pad of wipes sitting on my desk.
LISA PENDERGAST: So, I do think that there is that concern. And especially, I come from, more of a Wall Street background where you sit on trading desks. I would not want to be in a co-working area, in a trading desk environment. I mean, it's bad enough, right, because it's all kind of communal space to begin with and yet, I knew at least my space, every night I would go home and I would...
ADAM GOWER: And polish it up. Yeah, it's interesting you say that because my experience of co-working where I am now is that I did have my own space.
LISA PENDERGAST: That's different.
ADAM GOWER: I had a desk. I paid extra. This was my space. All the stuff was laid out. It wasn't a rotating desk.
LISA PENDERGAST: Okay. Different, yes.
How Commercial Real Estate Communications Has Adapted Since Covid
ADAM GOWER: I do want to ask you one thing. On your website, of all the things that CREFC does, one of the things it talks about is being a meeting place for industry professionals. Now, obviously, you mean that, not literally...
LISA PENDERGAST: Not today.
ADAM GOWER: So how are people, tell me because, you know, my business is all online. Capital formation, online. All remote, everything's done digitally. How have industry professionals adapted their communications over the last 6 months since this all started? And how do you think that will look in 12 months' time?
LISA PENDERGAST: You know, I think one of the attractions, and I'll make it quick, to CREFC, after being, sort of, in large banks, and the like, for most of my career, was that I was actually not leaving the business and staying with all my buddies that I, kind of, grew up with over the 30 years, in the business. The fact that, be it a Zoom or in person, I don't think it matters. We just recently had a virtual conference this week which went extremely well but I was touched by the number of people who called me and said, It was so fun to spend the whole day with my buddies again, with people I know, with hearing what they had to say and listening to the Woman of the Year Award. We awarded the award to Kara McShane from Wells Fargo and people were pleased about that. It, kind of, felt like old times for just a little bit. So it tells me that people can get used to many, many things. They miss seeing each other in person, but this, kind of, does okay to fill that gap. I think at the end of the day, commercial real estate is very much, this sounds trite, a people kind of business but it really is. You know, in our world we have, lenders, investors, servicers, loan servicers. All of those people have to work together, otherwise, you know, it really becomes difficult. So. I'm not sure I answered your question, but, I think I did.
