MARKET INSIGHTS
April 14, 2020

John B. Levy

by John B. Levy

We’re told that history repeats itself, and this Spring seems to be a perfect example. Our family’s Passover Seder dinner was conducted . . . via Zoom. . . with 17 participating family units from all over the country. More than 3.000 years ago, we seem to remember that Passover was started by plagues, though surely not Covid! The more things change, the more they stay the same!

Is it different this time?

  1. New commercial real estate (CRE) transactions, whether sales or financings, have slowed to a snail’s pace. At many firms, loan originators have been transferred to servicing in order to deal with a large number of requests for forbearance.
  2. Although forbearance requests have come in from all property types, the hospitality sector has suffered the most. Occupancy rates are less than 10% in many hotels with medical professionals and transportation workers the most prevalent guests.
  3. The big GSEs, Freddie Mac and Fannie Mae, have similar plans offering borrowers the right to request a payment deferral for up to three months subject to the operation of each property. But, to the surprise of many borrowers, the forbearance isn’t free! During the forbearance period, borrowers must remit ALL cash flow after expenses to the lender. We suspect more than a few borrowers will reconsider these requests after reading the fine print.
  4. With respect to loan workouts, this time feels “different.” During the global financial crisis, workouts were abundant with most investors and lenders feeling that borrowers brought the defaults on themselves by grossly over levering their holdings. We don’t get that sense today. Leverage points are lower than they were in the GFC and virtually everyone realizes that we are all in the COVID recession together. Banks and lenders, encouraged by regulators, are being more than flexible these days . . . at least for the next 60-90 days.
  5. Piling On: There’s no question that we are in unprecedented times due to the severity and rapidity of the COVID downturn. Nevertheless, we get the sense that a number of tenants and landlords are asking for rental/payment relief because they “can.” For example, lenders have noted borrowers requesting April payment forbearances before the rental payments were due.

    To be sure, no lender wants to encourage payment relief, but virtually all wish to work with borrowers who have legitimate cash flow needs. As a result, expect institutional investors to view each request based on the facts and circumstance and to set forbearance terms that don’t encourage borrowers to solicit them.

  6. Prologis (NYSE: PLD), the publicly traded industrial behemoth, noted that some 25% of its 5,500 tenants had requested some forbearance though they expected to grant only about 25% of the requests.
  7. The CMBS market was off to the races in the first quarter of 2020, up some 39% from the first quarter last year. New CMBS originations are virtually non-existent these days, so the second quarter will surely be a bomb.
  8. The G-L 2, our proprietary high-yield commercial real estate index, just released year-end results and celebrated 10 years of return data. The G-L 2 returns were more than a whopping 300 basis points over investment-grade CMBS and institutional grade whole loans for the 10-year time period as compared to our proprietary G-L 1 Index and Bloomberg Barclays.

    But it was not all smooth sailing. The G-L 2 noted reduced valuations on selected mezzanine loans at year-end. We are eagerly awaiting first quarter 2020 results as the previous returns don’t reflect the impact of COVID.

    The G-L 1 Index for institutional first mortgages has to date sported virtually undetectable levels of loan loss, 2 basis points for the year ending 2019. This contrasts with the peak reached during the global financial crisis of 100 basis points. We don’t expect that the second quarter 2020 losses will fair as well as 2019, but we don’t sense a tsunami of losses either.

  9. But the CRE world isn’t all doom and gloom these days. For lower leverage transactions, especially apartments, interest rates in the 3.25% and up range are still quite available.
  10. Property owners are an optimistic lot and don’t feel . . . for the most part . . . that their holdings have declined in value. But there have been precious few post-Covid sales, so there has truly been no recent “price discovery.” It will be summer before there is meaningful new sales data.

    Appraisers are in an especially uncomfortable position. Many properties with long track records . . . think hotels and retail . . . may have virtually no cash flow. So did those property values approach zero overnight? That’s not our opinion, but it makes for quite an argument.

    We welcome your thoughts and comments and would be delighted to discuss either new investments or new workout strategies.