The government money-printing presses are in full swing to rescue American people and businesses, but it may not be enough to save the commercial real estate market—or at least the lenders that back certain commercial deals.
I’m talking specifically about the hotel and travel industry, as well as the retail world. Many of these properties are funded by CMBS (commercial mortgage-backed securities) debt. According to Visual Capitalist, default rates in the CMBS world surged 792% between May and June.
Ratings agencies are growing increasingly nervous about the CMBS market—the business side of the residential mortgage-backed securities market that touched off the 2008 global financial crisis.
What Is CMBS Debt?
A commercial mortgage-backed security loan, also known as a conduit loan, is a type of commercial real estate loan that is backed by a first-position mortgage on a commercial property. These loans are packaged and sold by conduit lenders, commercial banks, investment banks, or syndicates of banks.
A CMBS loan has a fixed interest rate (which may or may not include an interest-only period) and is typically amortized over 25 to 30 years, with a balloon payment at the end of the term (typically about 10 years).
Because the loans are not held on the conduit lender’s balance sheet, CMBS loans are a great way for these lenders to provide an additional loan product to borrowers while at the same time maintaining their liquidity position. Because of the more flexible underwriting guidelines, CMBS loans also allow CRE investors who cannot usually meet stringent conventional liquidity and net worth guidelines to be able to invest in commercial real estate.
Anyone recall the 1980 spoof horror movie “Motel Hell?” Something about a farmer who planted his guests out in his garden. Probably alongside the celery. (Can you guess that I hate celery?)
I’m afraid that countless hotel owners are living their own hotel hell since coronavirus struck. And many lenders have been left holding the bag. In the midst of strict COVID-19 restrictions in April, REVPAR (revenue per average room) plummeted 84% to $16 per night.
Evaporating revenues at hotels and other hospitality-related businesses have spooked the CMBS lender world as delinquencies and defaults continue to rise at an unprecedented pace.
We thought 2019 was bad. In one of the strongest economies in world history, America saw almost 10,000 retail stores shuttered according to Business Insider. A.C. Moore, Sears, Kmart, Party City, and Walgreens were among the many store closures last year. The online revolution is obviously driving this trend.
We knew this sad party would continue in 2020 and into the future. But who could have guessed it would get to this level?
In March, with COVID exploding across the news, Coresight Research predicted 15,000 closures. But by June, it reported that U.S. retailers could announce between 20,000 and 25,000 store closures in 2020. America’s malls are home to over half of these closures.
Almost 20% of retail loans are in arrears. From January to June 2020, at least 15 major retailers have filed for bankruptcy, and over $20 billion in CMBS loans have exposure to flailing chains such as JCPenney, Neiman Marcus, and Macy’s (see above Visual Capitalist chart for a visual representation of the magnitude of this).
The Feds to the Rescue
The federal government’s revved up money-printing machines have stepped in to help rescue the CMBS realm. Typically, the government, which is involved in backstopping some agency debt (Fannie Mae and Freddie Mac), doesn’t back private lenders. But 2020 is anything but typical, right?
For multifamily and office, D.C.’s stimulus packages have helped tenants continue making payments thus far. Still, as the government will eventually halt stimulus packages, this shortfall in funding could be problematic.
The Federal Reserve has been purchasing high-quality CMBS loans in order to inject liquidity into the mortgage market. The assets backed by these loans house a multitude of small businesses that employ millions of Americans.nBut even with government help, current data show that their cash infusion can’t fix a problem of this magnitude.
The delinquency rate for all commercial properties tripled in a three-month period through June, to 10.32%, just short of the all-time record 10.34%, according to Trepp. Of these, 6.25% were seriously delinquent.
Here is the breakdown as reported by Visual Capitalist:
Coming Soon to a Town Near You
CMBS debt levels and delinquencies obviously vary widely by city. Our friends at Visual Capitalist have provided this helpful map showing the top 15 metros by delinquent CMBS balance.
The associated report also points out that:
“Despite the New York City metropolitan area having a delinquent balance of $7 billion, its delinquency rates fall on the lower end of the spectrum, at 7%. New York alone accounts for 18% of the total balance of private-label CMBS.
“By comparison, the Syracuse metropolitan area has an eye-opening delinquency rate of 69%. Syracuse is home to the shopping complex, Destiny USA, which is facing tenant uncertainties due to COVID-19. The six-story mall attracts 26 million visitors annually.”
The Significance of This Crisis
For perspective, realize that it took almost five years of declining revenues to get to this record low point (10.34% delinquencies) in 2012. It took about three months this time around.
When delinquencies drag on a while, typically for 60 days, they turn into defaults. And defaults lead to foreclosures. Between May and June, defaults in the CMBS market surged 792% to $5.5 billion.
Properties in default may eventually fall into foreclosure. When this occurs, institutional investors including pension funds and others will likely experience steep losses.
Where Do Aspiring Commercial Investors Go From Here?
Many of you are interested in commercial real estate. Like me a decade ago, you may be thinking about jumping up from residential to commercial. But also like me a decade ago, you may be wondering who to trust or where to start.
I invested in multifamily for some time. Then, I expanded into more recession-resistant assets, including self-storage and mobile home parks. You may want to consider these asset types or others like data centers and cell towers.
You may also want to prepare to acquire some of these foreclosures or even distressed debt. (Check out this NREI post on buying distressed debt.)
Howard Marks is the founder of Oaktree Capital. Marks has been called the “Distressed Debt King.” He has raised billions of dollars to deploy into the acquisition of distressed debt and assets over the past 30+ years.
In a Fall 2008 interview, a reporter asked him what type of financial instruments he was unloading. Marks informed the reporter that he was not selling but rather buying… as fast as he could! Up to $500 million per week.
Noting the reporter’s surprise, Marks said, “If not now… when?”
In his great book Mastering the Market Cycle: Getting the Odds in Your Favor, Marks said he hoped he would never see another downturn like the Great Financial Crisis. Though he made billions for him and his investors, he seemed to believe that situation would not be replicated in his lifetime.
But in light of COVID and his belief in the coming fallout, Marks is currently raising a record amount of cash to deploy into distressed debt… $15 billion dollars or more.
Howard is a pretty smart guy. Does he have a clue about what’s coming?
What do you think is coming? And what are you doing to prepare?
Leave a comment below.