Commercial Real Estate (CRE) continues to be an asset class filled with uncertainties. Initially, state lockdown orders decimated many CRE sectors. Unlike residential assets, government financial assistance mostly overlooked commercial assets, leading to higher default rates and forbearances with certain assets. The SBA PPP loans were instrumental in keeping many commercial real estate owners afloat during the worst of the COVID crisis. Government stimulus has mostly stopped and CRE lenders must now adapt to making CRE mortgage loans in the “new normal.” To get a pulse of what it was like to be a CRE lender, I interviewed three significant CRE mortgage lenders to get their take on mortgage lending in times of uncertainty. Below are a few questions and observations of the currently state of the CRE market.
Is Retail Truly Dead?
As anticipated, the challenges for retailers struggling before the current crisis, especially those that do not have online revenue streams, are growing. Retail entities demonstrating resilience, and even strength, are those equipped with in-line retail anchored by essential goods including grocery, discount, and pharmaceutical providers.
The CARES Act offered some degree of support for rent payments owed by small businesses. As retailers shuttered operations, landlords and lenders have been actively discussing payment options such as rent relief and deferrals, modifying leases, and addressing lease provisions to prevent tenants from vacating their lease obligations. CBRE released early estimates indicating that approximately 50% to 70% of April retail rents were paid on average at grocery-anchored centers, 20% to 40% in non-grocery anchored centers, and only 10% to 20% in malls and outlet centers.
To some extent, retail owners will have to absorb some of the financial burdens borne by tenants; however, the sponsors best positioned to weather the pandemic will be those proactively collaborating with all stakeholders, including lenders and investors. Commercial real estate lenders are continuing to provide funding options in the retail sector provided developers and tenants have a viable strategy for sustained revenue.
What Types of CRE assets Are Still Attractive?
The industrial sector is expected to outperform other asset classes as it becomes more essential for supply chains, e-commerce, and food and beverage suppliers. Distribution and manufacturing facilities are less prone to business interruptions than other commercial real estate classes because these entities are typically less crowded and are located in suburban locations.
Accordingly, industrial rents are anticipated to remain relatively stable. Leasing activity has gone down as potential tenants employ a wait-and-see approach and are finding it hard to complete the onsite inspections required for closing. Overall, leasing activity may rise in the near future due to an elevated need from high-demand industries such as last-mile distribution, cold storage, and e-commerce. Still, these positive effects may be somewhat negated by decreased interest from non-essential retail/ whole companies and third-party logistics that cater to them. The industrial sector will experience some short-term fluctuations but will likely recover faster than other property sectors.
In terms of geographical location, suburban areas outside of urban core markets are experiencing rapid growth prompted by the mass exodus from major metropolitan areas due to the viral outbreak. With the advent of telework and online schooling options, buyers and investors alike are exploring options outside the city where they can get more bang for their buck.
How do you Manage and Trust Asset Valuations?
While they are inherently different in some respects, like other financial assets, real estate assets are valued as if they implied series of cash flows in perpetuity. Although, unlike stocks, commercial real estate will physically depreciate, their owner’s reserve funds for periodic capital expenditure to mitigate the effects of depreciation and rendering them akin to perpetual assets. However, if, in the long run, asset values revert to their inflation adjusted mean, do episodic fluctuations like Covid-19 genuinely matter in valuation from a long-term perspective? In reality, the CRE market does care about the short run performance of an asset. Investors require a safe exit strategy and may have a target holding period.
While some may believe that the world’s response to the coronavirus is somewhat exaggerated, there should be no denial that the crisis will persist for many more months, if not years, and will fundamentally alter our collective worldview of nearly every aspect of personal and professional daily life. Even if Covid-19 does not lead to a permanent regime shift, its impact on cash flow projections must be incorporated into any valuation. Commercial real estate valuation has two primary inputs: (1) How much future cash flow a given property is anticipated to generate; and (2) The risk profile associated with the given asset.
Assuming the macroeconomic fluctuations are relatively minor, the data follows a fixed regime, making predicting future revenue streams easier. The associated risks including variables like discount rate and capitalization rate are determined by adding some premium to the exogenous risk-free rate. The risk metrics, therefore, are reflective of the uncertainty in cash flow whereas the cash flow estimates are about their projected levels. The stakeholders such as the appraisers, clients, and investors must take any valuations done today with a pinch of salt. In coming months, we should expect retrospective corrections to the valuations being conducted currently.
In these testing times, it is important to realize how ineffective the emerging valuation techniques including machine learning-based automated valuation methods are during this unique interruption in normal operating procedures. Accordingly, it is important to inject some degree of human augmentation and subjectivity to reach a collective industrial consensus as to how to implement needed adjustments to the valuation process. Lenders are taking a more deal-specific approach when it comes to funding. As far as rates go, CRE lenders are maintaining Loan to Value (LTV) at pre-COVID levels of 70-75%, while slightly increasing pricing from previous averages between 8-9% to closer to 10%.
Multifamily Sector Status from a Lending Perspective
COVID-19 will impact multifamily communities to varying degrees depending on asset and submarket contexts. The majority of lenders are focused on navigating upcoming rent payment cycles and accommodating tenants experiencing financial hardship to create deferred or partial payment plans. To date, no state has implemented a rent freeze and government officials continue to urge landlords to be flexible regarding payments. Major urban areas have rolled out eviction moratoriums for nonpayment of rent and are negotiating extensions of these policies into the fall season.
Markets that will face the biggest challenges are those that are primarily reliant on leisure, hospitality, and oil and gas industries such as Orlando, San Diego, and Houston. Revenue volatility may be more pronounced than vacancy concerns from a long-term perspective, as tenants navigate lower incomes or unemployment during what appears to be a U-shaped recovery. Stabilized properties will be the least impacted as people remain in their homes in the short term. However, as exhibited in prior recessionary periods during times of economic turbulence, households typically downsize to more affordable housing or double up in occupancy. Subsequently, Class B assets are best positioned to weather the crisis than the luxury sector as renters become more price conscious. Class C assets will also become stressed as lowerincome households experience increased financial uncertainty. Before the virus, demand for affordable housing greatly exceeded supply. The effects of the pandemic will only accentuate the focal challenge of housing affordability.
Managing Investor Expectations &
Capital Markets Outlook As the COVID-19 crisis pans out, the overall impact on the global economy is becoming increasingly apparent in supply chain disruptions, demand shocks due to social distancing, regional shutdowns, travel restrictions, and restricted consumer spending. Certain industries, including tourism, air travel, hospitality, and brick-and-mortar retail are experiencing the sharpest disruptions indemand while other industries are navigating compromised revenue and operations, and may halt hiring, expansions, or purchases. Recent unemployment numbers showed in an increase of new jobless claims to 22 million, wiping out a decade of hiring gains. Responding to the crisis, the U.S. government rolled out several unprecedented monetary and fiscal stimulus packages, exceeding the relief policies implemented during the 2008 economic crisis. All told, the stimulus is estimated to be more than $6 trillion, or 29% of annual GDP. While these actions will hopefully help mitigate the long-term economic fallout, it is premature to estimate the severity of the downturn and the shape of the recovery as the macro environment is still developing and remains highly uncertain.
The U.S. commercial real estate market has started to experience the impact of the pandemic. Hospitality, healthcare, and retail properties have seen the most pronounced impact, while other sectors reliant on longer-term leases should be better insulated. An extended cessation of economic activity to subdue the outbreak, continued employment reduction, and declining consumer demand would substantially affect demand for commercial real estate. It should be noted that, prior to the pandemic, the U.S. real estate market was exhibiting manageable levels of new supply, low vacancy rates, modest leverage, and large cap rate spread to the 10-year Treasury— all factors that would support a healthy commercial real estate market and mitigate potential value declines. While the impact from the COVID-19 crisis is severe, there is reason for optimism regarding the long-term U.S. economic outlook and commercial real estate industry.
Final Take
With US treasuries well below 1% and anticipated to stay there for some time, we are clearly in a yield-starved world. Even though CRE continues to post significant uncertainties, the fact of the matter is that most investments are even more uncertain and speculative. The equity markets continue to wildly swing, and valuations appear completely disconnected with underlying economic fundamentals. CRE mortgage lenders must now underwrite to numerous negative contingencies, but ultimately smart CRE bridge lenders have always had to navigate a transitionary asset and must rely upon their underwriting savvy more than ever. Ultimately all mortgage lenders are adapting to the new normal and learning their lessons in real time.
