Muted Distress in CMBS Loans Lets Investors Put COVID-19 in Their Rearview Mirrors

Article originally posted on CoStar on July 29, 2021

Second-Quarter Property Sales Boom Lends Evidence to Quick Recovery

The clouded outlook for commercial real estate during the pandemic has started to dissipate rapidly, according to CoStar data. (Getty Images)

The recovery from pandemic disruption in the commercial real estate market has advanced more rapidly than industry experts expected and is gaining speed even as variants of COVID-19 loom as a potential threat.

The amount of property distress is fading much faster than the market saw during the Great Recession. Real estate investment trusts have rebounded strongly. And the federal ban on evictions, a major protection for apartment renters, is coming to an end this week, which is viewed positively by investors now looking at the health crisis in their rearview mirrors.

About 6,890 loans on the commercial mortgage-backed securities market totaling $93 billion became 30 days delinquent during the pandemic through last month, CoStar data shows. That compares to about 7,570 CMBS loans totaling $112 billion between 2009 and 2010, the darkest period of the Great Recession, according to Xiaojing Li, managing director of CoStar Risk Analytics.

Notably, by the end of the first year of the Great Recession, 39% of the delinquent loans were liquidated at a loss or the property was foreclosed upon. For the pandemic, only 5% were disposed of as distressed assets by the 12th month.

Part of the reason for the strength of commercial real estate this year is that the industry never got as bad as many watchers feared, Li said.

Second-quarter U.S. property sales reached a whopping $188.1 billion — the highest second-quarter total this century, according to the latest data available from CoStar. Retail property sales hit a second-quarter high and were almost double any other second quarter since 2000. Industrial sales also marked a second-quarter century high. Hospitality sales saw the highest second-quarter total since 2007.

John Levy, principal of real estate investment banking company John B. Levy & Co., likened the past 16 months to going into the pandemic with a road map that was 100 years old and not knowing which way to go. Once the map was updated, it became pretty easy to see where and how to get to where the industry wanted to go.

“The risk last summer was that no one knew what to expect,” Levy told CoStar News in an interview. “We didn’t know what was coming. What we knew was that we hadn’t had a medical issue like that in 100 years. We didn’t know what the results would be, and we didn’t know how to model.”

According to Li, the pandemic’s troubled loans and properties didn’t move to distressed sales at the pace of the Great Recession for several reasons, including lenders being more lenient about allowing short-term forbearances, liquidity efforts by the Federal Reserve, the White House and Congress, and better underwriting and collateral status by lenders going into 2020.

“The pace so far is dramatically slower than what was in the last recession and sets the expectation for continued low levels of losses and foreclosures for the next 12 months,” Li said. “For now, it is too soon to say we are completely out of the woods and there would be no issue. There is still some uncertainty about office space use in the future, hotels filling back up and group events coming back. But the issue is smaller than what we originally projected. The stats do provide evidence for hope.”

REITs appear to have skipped a recovery phase and gone straight into expansion, analysts say.

U.S. trusts posted robust returns in the second quarter of 12%, bringing the year-to-date return to 21.3%, according to the industry trade group Nareit. Broader markets also had positive returns but lagged REITs, which put up an 8.5% return on the Russell 1000 in the second quarter and 15% for the first half of 2021.

Sectors Recover Differently

The year has produced a lot of encouraging surprises by property type, Calvin Schnure, Nareit’s senior vice president of research and economic analysis, told CoStar in an email.

The sectors that had been weakest during the winter and early spring have either showed early signs of stabilization, such as office, or are beginning to improve, namely retail. Meanwhile, sectors that had begun to recover last year, for example apartments, or had continued to grow during the pandemic, most prominently industrial, saw record increases in demand, falling vacancy rates and rising rents.

Industrial is one of the biggest surprises, Schnure said.

“The record growth in demand is nearly all for logistics facilities, of course, and given that e-commerce surged when bricks-and-mortar closed, one might have expected a slow period now,” he said. “But what we are seeing is the pandemic didn’t pull forward a fixed level of demand, which would have left a vacuum in its wake. Instead, it accelerated the growth of demand, and the convenience of e-commerce means it is continuing to grow from a higher level, even as the stores and malls reopen.”

Retail too was a surprise, particularly that net absorption, the total amount of physically occupied space subtracted from the total amount of space tenants moved out of, was so large, Schnure added.

Net retail absorption in the second quarter was 17.9 million square feet, the highest quarterly total in three years, according to CoStar.

“I’ve been expecting new stores to open to replace the ones that closed/failed, but I didn’t think it would happen so soon,” Schnure said. “That’s good news for the retail property market.”

Benefit From Evictions Returning

The expiration of the Centers for Disease Control and Prevention moratorium on evictions, set for Saturday, could give a boost to the multifamily market. Though the Federal Housing Finance Agency and a handful of states such as New York will still provide some extra protection for renters who can’t pay, the resumption of evictions nationwide is expected to lower tenant delinquencies and increase cash flow, according to Moody’s Investors Service. That’s a plus for landlords and their lenders, including REITs, housing finance agencies, and securitizations tied to single-family or multifamily rental units.

“Among CMBS loans, multifamily had the second-lowest delinquency rate among core property types, after industrial,” Kevin Fagan, vice president and senior credit officer for Moody’s CMBS group, said in an email to CoStar. “There was a minor amount of differentiation across markets, with more multifamily delinquencies where there was the biggest COVID impact, and with the most economic reliance on services, tourism or oil.”

However, Fagan added, the multifamily market was resilient, with many factors playing a role. The jobs that renters lost were the type of positions that companies were the fastest to hire back.

“After the dust settled and an economic rebound began in the second half of 2020 and was amplified by mass vaccinations in the first half of 2021, there still remains the fact that housing demand has generally outpaced supply, and the new supply threatened by foreclosures or evictions does little to close the supply-demand gap,” Fagan said.

But how much should the impact of COVID-19 on commercial real estate be viewed as a thing of the past? It’s hard to say, according to Fagan. Employment has not yet fully recovered, and office workers are typically harder to rehire after a downturn.

“And of course, we do not know the extent to which the variants of COVID will propagate and result in further business disruption,” he said.

The delta variant is spreading more widely in regions where vaccination rates are low. That makes its harder to predict whether it will have a wide impact or be more localized, according to Levy, the investment banker. In addition, it is hard to know how individual firms will respond.

Tech giant Apple, one of the first companies to send employees home at the pandemic’s start and one of the biggest proponents of bringing them back, announced plans this month to postpone reopening offices by one month after a spike in coronavirus cases.