More owners have been able to catch up delinquent loans, which has short circuited predictions of a massive pandemic-induced distressed real estate cycle.
Mortgage delinquency rates, which have been a bellwether of distress in the commercial real estate sector during the pandemic, are continuing to improve. One area of concern, however, is that elevated levels of delinquencies in the lodging and retail sectors are expected to linger as troubled loans slowly work toward resolutions, with some defaults expected.
All property types saw slight improvement in delinquencies with the overall rate improving by 30 basis points in July to 95.5 percent, according to the MBA’s CREF Loan Performance survey. Lodging and retail property loans continue to experience the highest levels of stress. Lodging delinquencies improved from 17.6 percent in June to 16.5 percent in July, while retail loan delinquencies dropped from 10.0 to 9.0 percent. CMBS loan delinquencies also are higher than other capital sources at 8.2 percent.
There are still a lot of “what ifs” that will influence how the amount of distress in commercial real estate will play out. Some believe that distress has peaked and is gradually being worked out. Others think there could be more flare-ups of distress ahead in certain pockets, especially once forbearance and government stimulus disappears. The Delta COVID-19 variant is another wildcard that could significantly weigh on the economic recovery and stall returning momentum within property sectors, notably lodging and even offices as rising cases are causing many companies to delay return-to-office plans
Despite all of this, the massive wave of distress that some had predicted at the beginning of the pandemic has not materialized. For example, last December CoStar released data from its predictive modelling that projected 16 different scenarios for the volume of distressed asset sales that could potentially occur over the next five years based on different assumptions. Models ranged from a high of $659 billion to a low of $134 billion with a median topping out at about $321 billion. CoStar has since pulled back from those models, in large part because there are so many unique variables in the current market that are influencing the outcome of troubled loans. In addition, some downside assumptions included in the models never materialized.
“There are still a lot of uncertainties to monitor, but my new expectation is that the distressed loan volume will be dramatically reduced if we can keep the recovery speed that we have right now,” says Xiaojing Li, managing director Risk Analytics at CoStar.
There are a number of factors why the distress is less severe and steps to resolve loans have been more effective. The government stimulus and forbearance have played a big role in curbing distress. In addition, properties across the board are generally carrying lower leverage debt and pre-pandemic underwriting on valuations was sound, which puts borrowers in a better position for recovery.
A path forward for troubled loans
There are different solutions for troubled loans. In some cases, a borrower simply needs more time and continued recovery to move that loan back to performing. Another option is to bring in new equity and/or restructure the loan. The third route is for that troubled loan to be liquidated through a discounted payoff or foreclosure and REO or note sale.
Historic stimulus programs along with lender forbearance and moratoriums on litigation have given borrowers more time to resolve distressed situations. “We’ve seen the majority of lenders choosing to delay decisions over the last 18 months simply because they could afford to wait,” says Patrick Arangio, vice chairman of the national loan and portfolio sale advisory practice at CBRE.
At the same time, abundant liquidity coupled with the prolonged low interest rate environment is also affording borrowers more options. “There is a historically significant volume of capital earmarked for investment by institutions that are specifically targeting opportunistic investing through loan sales, distressed real estate sales, recapitalizations, etcetera,” says Arangio. “That level of liquidity, in combination with this interest rate environment, limits the volume of distressed product. As such, we have seen, and continue to see, a pronounced supply versus demand imbalance.”
That capital is circling troubled lodging and retail in hopes of capturing some opportunistic deals. Hotels were very much “risk-off” during the height of the pandemic, notes Arangio. “In the last three quarters we have seen a significant influx of both debt and equity capital with the express goal of investing in hospitality,” he says. “We expected that it would happen, but the speed and scale of the return to the sector has been notable.” The overarching caveat is that there is a flight to quality. The pool of interested bidders on distressed hotel loans tends to be smaller for full-service hotels dependent on group bookings and convention business, as well as older capital-intensive hotels, those with ground leases and hotels with unionized labor. “That said, we continue to see very active participation for any opportunistic transactions,” he adds.
Retail is facing vastly different challenges as the sector was impacted by the pandemic, as well as underlying issues related to increased competition from e-commerce and changing consumer behavior. The distress that has emerged is concentrated in high street retail in major CBDs and class-B regional malls. “We’re anticipating that it is going to take longer for some of the high street retail to recover, and frankly, some of the B and C malls may never recover,” says Jack Howard, executive vice president in the National Loan & Portfolio Sale Advisory practice at CBRE. So, there is likely to be more troubled loans ahead for B and C malls, he notes.
Deep discounts remain rare
Delinquencies in lodging and retail could remain elevated for some time. For a property to fully move through the process of delinquency to foreclosure, REO and an eventual sale it can take up to three years, notes Li. “In this case, I think it will take longer because of the level of forbearance that will further delay some of the resolutions,” she says. The additional time, whether it is from forbearance or lenders willing to be patient, could end up benefitting borrowers, because it will give borrowers more time to recover, she adds.
CoStar conducted a historical comparison of troubled loans following the Great Financial Crisis in 2009-10 and the COVID-19 downturn in 2020. The results show that 35 percent of the CMBS loans that became delinquent 12 months after the financial crisis were liquidated, either resolved through note sales or REO property sales. At month 24, the percentage of delinquent loans that were liquidated rose to 54 percent. The same analysis of troubled loans that occurred following the COVID-19 downturn shows very different results. Only 5 percent of delinquent CMBS loans were liquidated at month 12. It remains to be seen how much those numbers might rise by month 24. However, the early data shows a dramatically different scenario to date, notes Li. Li expects the percentage of liquidated loans to remain muted, likely staying below 10 percent.
In addition, the deep discounts that many investors had hoped for on distressed REO and note sales have not materialized to a significant extent. Although there have been anecdotal examples of deeply discounted loan sales, the majority of values have held up fairly well. Limited service hotels are one sector that bounced back very quickly. For example, CBRE recently had bids north of 95 percent of the outstanding principal balance on the sale of a non-performing limited service hotel loan. “So, you could argue that some of the distressed product isn’t trading at distressed pricing,” says Howard.
Values have held up in large part from simple supply and demand fundamentals. The amount of capital raised for opportunistic investments far outweighs the volume of distressed assets that have emerged. “We are seeing record participation in loan sales which reflects the amount of capital that has been raised and continues to support loan values,” adds Howard.