Real Estate News & Commentary

Will Delinquent Loans Drag the Commercial Sector Into Ruin?

Expertise: Personal Development, Commercial Real Estate, Real Estate News & Commentary, Landlording & Rental Properties
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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.

Related: Why Fears About Looming Inflation Are NOT Overblown (& a Heckuva Silver Lining for Buy and Hold Investors)

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.

Hotel Hell

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.

Red hotel sign on top of a dirty old motel isolated on blue sky background with birds

Related: 7 Emerging Trends Shaping Real Estate Markets in 2020

Retail Apocalypse

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:

Per Visual Capitalist

Related: Key Takeaways From the ’08 Recession That Apply Today

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.

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“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.

After graduating with an engineering degree and then an MBA from Ohio State, Paul entered the management development track at Ford Motor Company in Detroit. After five years, he departed to start a...
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    Chris Montgomery Real Estate Investor from Steamboat Springs, CO
    Replied about 1 month ago
    Paul. Enjoyed the article. Thanks for sharing the research. One note: You defined RevPar as revenue per average room. Small difference but it's generally defined as revenue per available room.
    Paul Moore Investor from Lynchburg, VA
    Replied about 1 month ago
    Thanks Chris! Great catch. I have always been wrong about that and it is good to know.
    Colin G Murphy Investor from Tampa, FL
    Replied about 1 month ago
    Thank you Paul, lot of fascinating info in there and appreciate you sharing with us.
    Paul Moore Investor from Lynchburg, VA
    Replied about 1 month ago
    Thanks Colin! You're welcome.
    Ray Slack Investor from Bowie, Maryland
    Replied about 1 month ago
    The government needs to stop trying to prop up failing businesses by printing more money and giving it away.. I would say 50% of nightclubs and restaurants will fail and need to close. The landlords will need to lower their rent to the next tenant as there will be less demand for retail. Nothing will stop this other than a vaccine for all type of Corona Virus including the new strand D614G that is spreading across Malaysia. Throwing a little bit of money into the hands of small business owners is just throwing away tax payer money.
    Howard Mintz
    Replied about 1 month ago
    Just listened to a presentation from the American College of Chest Physicians regarding COVID 19, the new strain D614G is sensitive to the current vaccines under development and there are multiple vaccines that are showing excellent promise. The routine press reporting on all issues health is really horrible and uninformed. Reply
    Paul Moore Investor from Lynchburg, VA
    Replied about 1 month ago
    Interesting thoughts, Ray. I just got off a call where deflation was predicted. It sounds like that is the outcome if they follow the path you mentioned. I see likely deflation then large inflation in the aftermath.
    Tony P. Lender from Spokane, WA
    Replied about 1 month ago
    Good stuff Paul, thanks for sharing. Question: How do you invest in cell towers? What does that look like, out of curiosity...
    Paul Moore Investor from Lynchburg, VA
    Replied about 1 month ago
    Tony. Investing in cell towers was actually my first failed commercial investment. It was late 2000 and I was bored. I located a cell tower company and asked them where they needed better coverage in my region, and they told me about a dead spot they wanted to fill. I found five acres FSBO in that area and acquired it quickly. Within months I was under a conditional contract with the cell tower company. I was already thinking about what I’d do with that hefty monthly check. And also where I’d find my next deal. They had a year for due diligence and 9/11 hit right in the middle of that time period. The tower company closed their office and I never heard from them again. Years later I tried to restart that strategy and after months of location work, I abandoned it again. It wasn’t as easy as it looked. But cell towers are still a great investment! In exchange for a quarter acre of land and a deeded easement for access, investors can earn a steady income for decades. Another way to accomplish this is to buy out someone else’s existing income stream for a cash payout from you. Or to invest with someone who does. This sector has obviously grown a lot during COVID, and I think it will continue to do so.
    Karl B. Rental Property Investor from Columbia, MO
    Replied about 1 month ago
    Minneapolis at a 47% delinquent balance. Wowza. Syracuse at 69%... Wowzaaaaaaaaaa!
    Paul Moore Investor from Lynchburg, VA
    Replied about 1 month ago
    Yeah right! Stunning.
    Austin Gunnerson
    Replied about 1 month ago
    What a quality post. I took notes and learned a lot, thank you for sharing! Delaying doomsday to watch the stock prices rise today just to crash and burn tomorrow is a scary path. Sitting on cash for a buy in later and praying for those who haven't seen The Big Short...
    Paul Moore Investor from Lynchburg, VA
    Replied about 1 month ago
    Austin, That's very kind of you to say! Yes, I agree and your strategy makes a lot of sense, too.
    Tuck Bonham
    Replied about 1 month ago
    I’ve followed Howard Marks for years and this news does not bode well for commercial real estate. In addition to that Warren Buffet is buying into Barrick Gold ! Both of these investors seem to be concerned about this market.
    Christopher Smith Investor from brentwood, california
    Replied about 1 month ago
    Of course Buffett also very recently added pretty massively to his holdings of STOR Reit which is all about retail. I made my first jump into store during the big dip as well. I'm not much into retail but STOR continues to do well with solid collections that are continuing to trend up with no dividend cut anticipated. So it may end up being as much about quality portfolio management as it is about retail per se.
    Paul Moore Investor from Lynchburg, VA
    Replied about 1 month ago
    Yes, Marks has a stellar record. And I was surprised about Buffett's move as well. I believe Marks over the quick V-shaped recovery folks, but I really hope Marks (and I) are wrong.
    Ned Cavasian
    Replied about 1 month ago
    Another thing that will add to the problems of commercial class A properties I think is that more an more people are going to be working remotely even after all this passes so expensive cities apartments are going to take a hit due to that too (e.g. this is going on in San Francisco right now with some high tech companies allowing workers to stay remote even after all this has passed). On another subject, since service level workers got hit the hardest in this, are you looking to maybe do another mobile home park fund that starts with properties bought at discounts post pandemic and is not tied to anything at pre-pandemic prices?
    Paul Moore Investor from Lynchburg, VA
    Replied about 1 month ago
    Ned, That all makes sense. And it points to a painful future. Yes, we are thinking about another fund like that - to acquire distressed debts and assets. Could be in mobile home parks and self-storage and even multifamily. Thank you.
    Howard Mintz
    Replied about 1 month ago
    Just listened to a presentation from the American College of Chest Physicians regarding COVID 19, the new strain D614G is sensitive to the current vaccines under development and there are multiple vaccines that are showing excellent promise. The routine press reporting on all issues health is really horrible and uninformed.
    Paul Moore Investor from Lynchburg, VA
    Replied about 1 month ago
    Howard, That is great to know! Thanks for the update.
    Mike Morocco jr
    Replied about 1 month ago
    Excellent article! Thanks for posting.
    Paul Moore Investor from Lynchburg, VA
    Replied about 1 month ago
    Thank you, Mike!
    James Phan Rental Property Investor from California, CA
    Replied about 1 month ago
    Nice article. I’ve been reading Howard Marks memos and use it as a guide for investments.
    Paul Moore Investor from Lynchburg, VA
    Replied about 1 month ago
    James, I have really enjoyed reading his stuff, too. We're in good company. I hear Warren Buffett drops everything to read his stuff when it comes out.
    Sri Ram Rental Property Investor from West Palm Beach, FL
    Replied about 1 month ago
    Great article Paul as always. Very informative. Looking forward for the next fund.
    Paul Moore Investor from Lynchburg, VA
    Replied about 1 month ago
    Thanks so much, Sri! Very kind of you.
    Tim F. from Fairfax, VA
    Replied about 1 month ago
    Great article! This might be a dumb question, are there other companies that specialize in investing during distressed markets to capitalize on the downturn?
    Paul Moore Investor from Lynchburg, VA
    Replied about 1 month ago
    Hi Tim, Thank you! Not a dumb question at all. I've been researching this since April and yes, there are a bunch of small players that try to stay under about $5-10mm per deal to avoid the big players.
    Evan Loader Rental Property Investor from Ann Arbor, MI
    Replied 28 days ago
    Paul, do you know if it is possible to passively invest in distressed debt as a sophisticated investor? Are there people who cater to such a situation? I am not yet accredited.
    Chelsea Shapiro Real Estate Broker from Seattle & Greater Puget Sound Area
    Replied 29 days ago
    Fantastic article, thank you! Per the map graphic it really seems like this will have a big impact in certain markets, do you anticipate it remaining insular, or do you forsee it being more widespread? I'm the Seattle market which didn't make it on the map, so far some of the CRE impact doesnt seem as harmful as other areas, and the biggest trend seems to be a continued re-location across the lake to Bellevue to avoid Seattle policy.
    Paul Moore Investor from Lynchburg, VA
    Replied 28 days ago
    Hi Chelsea, I can only guess that it will be widespread. But as we are seeing this unfold, we see that cities with lots of rioting and heavy-handed political over-reach are being abandoned. Like NYC and Chicago. So I am guessing those will be hurt much more in the end. NY, for example, has had trouble before. BUT it is really different this time in that for the first time, it is proven (on a wide scale) that employees can work from home. That is new, and may make this devastating for employment centers like New York and Chicago, etc. I know that we are seeing a mass influx of people here at Smith Mountain Lake in Virginia. The Blue Ridge Mountains and the lake make this a great place to relocate and we are within an 8-hour drive of over half of the US population from what I understand.