Commercial mortgage securities could be the next flashpoint



The coronavirus pandemic and the resulting economic crisis are driving dramatic and long-term changes in the commercial real estate industry as e-commerce strengthens its dominance and businesses reduce overhead costs by keeping employees working from home.

These changes threaten not only the companies that build and rent office towers, shopping malls, industrial complexes and apartment buildings, but also the banks, life insurance companies and pension funds that invest in them. . Ultimately, the extent of the crisis and the disruption it causes in the financial system could determine how quickly the commercial real estate industry will recover from the recession.

Commercial real estate investors face problems similar to those faced by residential real estate investors in the years leading up to the real estate crisis of over ten years ago. As with homes, most commercial properties are purchased with mortgages, which are then consolidated into titles and sold to investors, whose returns depend on the owners’ monthly payments.

With businesses struggling after government-ordered closures and other social distancing measures, cash-strapped commercial tenants miss lease payments and their landlords miss mortgage payments, undermining the value of backed securities to mortgages. If debt deteriorates, it could put a dent in investors’ balance sheets, dry up the capital needed to revive the commercial real estate market, and hurt the returns of institutions, such as pension funds, on which millions of Americans depend.

Private pension funds hold about $ 30.3 billion in commercial mortgages, according to the Federal Reserve.

“How bad it’s going to be – I don’t know,” said Jeff Davis, managing director of financial advisory firm Mercer Capital. “It’s a smelly mess, it is.”

According to the rating agency Fitch Ratings, more than 6,700 borrowers have contacted their agents asking for options for relief on $ 149 billion in outstanding commercial mortgages that have been grouped into securities, according to the rating agency. Fitch Ratings (Fitch is owned by Hearst, which also owns the Houston Chronicle). And more than $ 52 billion in title-backed mortgages missed their rent payments on April 1, according to securities data firm Trepp.

While all commercial real estate debt is at risk, mortgages bundled into securities tend to cover a higher percentage of a property’s value. Plus, most mortgages are interest-only, which means borrowers never pay back the principal they borrowed.

This is a risk if rental income dries up and property values ​​fall, as foreclosure of the asset may not recover the money that was loaned out, leaving a hole in the balance sheets of those who hold the property. debt. The potential impact extends beyond the financial sector – according to the Federal Reserve, private pension funds had $ 30.3 billion.

The situation echoes the collapse of the residential mortgage-backed securities market, which was at the heart of the financial crisis that began in 2007. But experts say the situation today is not as dire. While unscrupulous loans were rife in the pre-Great Recession period, often requiring a 0% reduction, commercial mortgages currently grouped into securities typically do not cover more than 75% of a building’s value. This means that the value of the building would have to drop by more than 25% before a homeowner owes more than the value of the asset.

(A 2019 whistleblower complaint filed with the Securities Exchange Commission claims that securities lenders and issuers artificially inflated financial data in order to grant larger loans, according to a ProPublica report. That would mean those mortgages cover a higher percentage of property values ​​- and a higher risk – than investors realized.)

Value risk

Since commercial real estate derives much of its value from rents, values ​​could drop if tenants fail and the remaining businesses need less physical space.

“People are going to offer fractions of what they used to offer for properties,” said Manus Clancy, senior general manager of Trepp. “You’re going to see the values ​​go down – for offices, shops, hotels, and so on. “

The potential impact on commercial real estate will depend on the demand for commercial space upon exiting the closure.

At one end of the spectrum of possible outcomes, if business soon returns to normal, Davis believes the period of missed rents will be a downside with little impact on real estate values.

But on the other end of the possible outcomes, if enough businesses disappear to increase vacancy rates and a pivot to a digital economy means that the businesses that remain need less retail space and office space, there will be an overabundance of commercial space in the market, driving down prices at the same time that homeowners are most likely to default.

“In this scenario, the value of the underlying collateral for commercial mortgages is drastically altered, which means that it has decreased significantly because the cash flow for a given development has just declined,” Davis said. “At the end of the day, what’s happening is not good for the commercial mortgage industry.

Congress has acted swiftly to prevent massive home foreclosures that can drop home values, but aid to help small businesses pay rent – called the Paycheck Protection Program – has run into many problems. According to a survey by the Greater Houston Partnership, an economic development group, only 60% of local small businesses that applied for help under federal stimulus programs put in place in March received it in late April.

The rest had to negotiate rents with their landlords, many of whom had to seek help with their own monthly obligations. Those with loans that have been bundled into commercial mortgage-backed securities face greater hurdles than those held by banks.

George Marshall, executive director of Amegy Bank, said all of the bank’s customers who operate a hotel have asked for relief, as have many of its mall owners and investors. Amegy keeps her loans, instead of selling them under commercial mortgage-backed securities, and was able to quickly provide such relief by drastically reducing payments for up to six months for clients whose income has been impacted by the pandemic.

“Seized” market

When a homeowner with a loan that has been packaged in a commercial mortgage-backed title tries to apply for relief, the process is much more complicated, said Brian Stoffers, global president of debt and structured refinancing at the real estate company. commercial CBRE.

Different companies handle loan repayments, and the securities are divided into different parts, called installments, which represent a hierarchical order of who is repaid first. The tranches that will only be repaid once other investors are known as B-pieces in the financial world, and the main holders of this high-risk debt include asset managers and services specials such as Rialto Capital Advisors, KKR Real Estate Credit, Eightfold Real Estate Capital and Prime Finance, according to data from Trepp.

“It has become difficult for buyers of existing loans who need forbearance to get relief… because of the way the bonds were created and the different levels of approval needed to get forbearance.” Stoffers said.

Homeowners whose loans are backed by commercial mortgage-backed securities may also face challenges as the loans were initially riskier. “These are loans that are generally taken out more aggressively,” Stoffers said. “They have higher loan values, higher rates, and they will lend on a wider range of types and qualities of property.”

As a result, few are currently willing to buy commercial mortgage-backed securities, essentially freezing the market, he explained.

“This market has seized up,” he said. “If you aggregated it before COVID and the market turns, you now have a portfolio of returns that are worth much less than what you created.”

Commercial Mortgage Backed Securities currently show how many of their loans missed their May payments. Of the roughly 70 percent who have already reported, 7.3 percent of loans – and 19 percent of hotel and retail loans – are at least 30 days past due. “All of these statistics are in the foreground right now, much the same way subprime mortgages were in the foreground during the last financial crisis,” Clancy said.


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