Fed stimulus expansion could save commercial mortgage market on brink of collapse
For the first time in history, the world has voluntarily and simultaneously braked the giant economic train we have created over the past few centuries. Businesses are closed, public places are banned and millions upon millions have been ordered to stay at home. The good news is that it seems to be working to help our medical system deal with the coronavirus we all know as COVID-19. The bad news is that although we’ve demonstrated that we can shut down the engine of the train, you can’t do the same with the other cars that are attached behind it. If this temporary shutdown lasts too long, we risk seeing the financial baggage of the world, unable to break under its momentum, come crashing down on us, sending us into a financial crisis that would cause widespread recessions and all the suffering that goes with it. .
Most of the real estate industry has already realized that many rents will not be paid. Residential and commercial tenants are facing a cash crunch, with many unable to pay their rents. It is already reported that approximately a third of residential tenants didn’t pay April rent and corporate tenants like Cheesecake Factory, Equinox and even WeWork have already told landlords they won’t pay rent on some or all of their locations, with some using the ” force majeure” as a reason to renegotiate payment terms or completely break their leases. Landlords are finding creative ways to help their tenants through the shutdown, such as what’s called a “mix and extend” lease modification that grants a temporary rent holiday and amortizes unpaid rent over the remainder of the term of the lease. lease. But these creative solutions will only help cushion the blow, not stop it, especially since commercial buildings are valued by their cash flow, which has been disrupted if not reduced.
Governments around the world understand the imminent threat this shutdown poses to our real estate values and therefore to our financial systems and economic future. In the United States, the federal government has created a record $2 trillion financial stimulus package that includes universal payments to low-income citizens, business loans and new regulations that allow mortgage forbearance and ban evictions. . These measures included $100 billion for a program called the Term Asset-Backed Securities Loan Facility of TALF. This organization was created in the wake of the Great Recession where it is widely credited with helping to bring stability after credit markets collapsed due to the (over)securitization of mortgages. Last month, TALF was reimbursed and given the mission to “serve as financial support to facilitate the issuance of eligible ABS on or after March 23, 2020”. This means that any new loans will not be covered by the program, but this, just as we learn with almost everything in our lives, is subject to change.
But there were limits to who was eligible for TALF. Initially, relief loans were only given to “agency” CMBSs, in other words, those purchased by Fannie Mae and FreddieMac. While this represents a large portion of multi-family residential mortgage bonds, it is only part of the commercial lending landscape. Only providing support for certain types of real estate debt securities threatened to hurt the valuations of millions of commercial properties and put a strain on the commercial mortgage market. The uncertainty has exerted downward pressure on the future profitability, and therefore on the current value, of the majority of buildings in the country.
The stress fractures of this tension first manifested themselves in commercial mortgage spreads, the difference between the base index rate, which is at an all-time low, and the spread at which lenders were actually willing to fund the loans. I talked to Constantine Korologos, clinical assistant professor of real estate at the NYU Schack Institute about it. Constantine, his name is Tino, knows a thing or two about the volatility of mortgage-backed securities. He previously worked as Managing Director for Deloitte Financial Advisory Services. “My first day was September 15, 2008, Lehman Monday,” he said with the kind of laughter that accompanies the memory of past angst. “I showed up to work and watched all the market dashboards go crazy. But even then, we haven’t seen such wild swings in Triple-A rated CMBS spreads on the ten-year swap. Amid pandemic fears, it was up to 300 basis points,” he said.
Just to take a step back, commercial lenders sometimes use Treasury swap rates as an index. The ten-year Treasury swap tends to closely reflect free market expectations of future Treasury rates. Treasury bills that mature in ten years are generally considered one of the safest places to put money. A basis point is one hundredth of a percent, so three hundred basis points is a full three percentage points. The fact that lending spreads are measured in basis points shows how small variations in these spreads generally tend to be, that they are measured in a metric that is an order of magnitude smaller than what we are currently seeing. “At the beginning of the year we were dealing with AAA CMBS spreads of around 10 years of 78 basis points on the ten year swap, so we saw them more than triple,” Tino said to give a bit of context.
The rapid rise in CMBS spreads had everything to do with risk. Lenders were concerned about commercial mortgages, which could default due to non-payment of rent and lack the same kind of protection as their residential counterparts. Fannie and Freddy participate in the CMBS market, they have become one of the biggest buyers of multi-family loans since the launch of TALFbut that only makes up for it approximately one-tenth of the entire commercial lending securities landscape. This would leave most CMBS lenders and investors exposed to the imminent loss of property value.
From now on, since April 9, the recovery plan received another $2.4 trillion in funding to help credit markets. On top of all that extra “dry powder”, TALF has been extended to include top-rated asset-backed securities including RMBS and CMBS bonds. With the Fed providing liquidity for these bonds while holding them on its balance sheet, it is believed that commercial mortgage-backed securities will have more market price discovery and hopefully less volatility, at least while we all hope to be a temporary crisis. But while CMBS loans are a good indicator of investor sentiment in a world where very few new loans are issued and therefore no firm market price is set, they represent only a fraction of the total supply of commercial mortgage loans. “The CMBS market represents less than 15% of total outstanding commercial debt,” Tino said. “Banks own about 40%, government agencies about 20%, and life insurance companies own about 15%. It’s the 40% of commercial mortgages held by federally regulated banks, with a 2019 year-end balance of around $1.4 trillion, that could pose a huge problem. These banks will face challenges and we don’t yet know if they will be able to withstand this decline in value due to market stress or if we will see bankruptcies and bailouts like we did in 2008.”
When the markets open on Monday, we will see how this increased fiscal stimulus affects the CMBS market, but it may be months before we fully understand what is happening to commercial lending more broadly. The fact is still true that very little debt is generated. Hundreds of millions of dollars in loans are due which, if not temporarily modified or restructured, will need to be refinanced in a turbulent and uncertain market. One of the things that could help our healthcare system catch up with the virus and give us time for the economic strain to start its slow restart. According to Hall Estill law firm shareholder Jeff Friedman, “The good news for CMBS borrowers is that handlers and special handlers, those third parties charged with handling distressed CMBS loans, are extremely slow to act when times are tough. So when the entire market is under such extreme stress, these repairmen will be underwater for a while playing yardage.
Discover Propmodo’s COVID-19 coverage→