Monitoring Resiliency and Credit Risk in the Commercial Real Estate Debt Market

High-quality credit has played a key role in keeping US real estate sectors afloat, but managing uncertainty risk will be key as we emerge from the pandemic, says Joseph Rubin, Consultant, Financial Advisory Services at professional services firm EisnerAmper 
 

The US commercial mortgage finance market reopened remarkably quickly after the start of the pandemic. Today, it is flush with capital for most types of real estate investments. Over the past year, investors such as banks, insurance companies, commercial mortgage-backed securities (CMBS) issuers, mortgage REITs, and private debt funds have been allocating increasing amounts of capital to stable and transitional properties and construction projects. 

The resiliency of the debt markets has greatly softened the blow of the pandemic, by providing liquidity to property owners squeezed by lower rent collections. Fannie Mae and Freddie Mac tightened their underwriting standards but continued to insure multi-family housing loans in significant volumes. Remarkably, the CMBS market, which took three years to recover from the Global Financial Crisis, was originating loans again by Summer 2020 and is seeing robust volume so far in 2021. 

Banks and insurance companies pulled back last year while they triaged their existing portfolios, but quickly returned to business. The willingness of banks to provide warehouse lines has resulted in a profusion of new debt funds – sponsored by private equity, real estate developers, family offices, and entrepreneurs – that are providing transitional and construction loans. This debt fund activity has also been bolstered by the strong resurgence of commercial real estate collateralized loan obligation (CLO) securitization, enabling funds to frequently recycle their capital.

A Changing Landscape  
While the market’s resiliency has been celebrated, this abundance of capital has its risks. Lenders have had to compete fiercely for deals over the past six months, and that rarely bodes well for maintaining credit quality. This competition has given borrowers the upper hand, making the work of loan credit officers more difficult than in the past. Anecdotally, most lenders are keeping loan-to-value ratios at conservative levels, but they are waiving covenants and lowering reserve funds in a period of often unpredictable cash flows. 

Typically, the recovery from an economic trough is the best time to underwrite loans. Property values have fallen, and cash flows are trending upward. However, today’s lending environment is unusually complex. In projecting property performance, lenders must consider changes in consumer behaviors, migration away from large urban centers, evolving patterns of working from home and in the office, and the rising cost of labor and materials.

On a macro level, loan credit could be impacted by a resurgence of higher longer-term inflation, rising interest rates, tax proposals curtailing like-kind exchanges, and increasing capital gains tax rates. The continued threat of COVID-19 variants around the globe is also a key risk to consider. 

Given such uncertainty, one could logically assume that credit spreads, especially for longer-duration loans, are at their highest in a decade. But competition has driven spread compression; in fact, permanent multi-family and industrial loan spreads are priced tighter today than before the pandemic. Whether lenders are being adequately paid for the term and refinance risk they are assuming will be determined over the next few years.

Finding the Balance
Of course, every commercial property is unique, and the pandemic demonstrated that performance by property type and market can widely diverge. As a result, lenders must update their credit playbooks and dive deeper than before when assessing the strength of a property’s cash flow estimates. With these assessments, reviewing both the resiliency of occupancy and rental rates during the past 15 months, as well as the likelihood of continued recovery during the term of the loan, will be essential. 

To date, capital has been abundantly available for multi-family and industrial real estate, increasingly available for hotels, less available for office, and much less available for retail. Will lenders be able to maintain the discipline to sort through the data and separate the likely winners from losers amid intense competition? 

Without trying to oversimplify the analysis, here are a few key considerations in balancing resiliency and risk by property type:

Retail: Retail remains lenders’ least favorite property type, and for good reason. The sector is massively overbuilt and vulnerable to changes in consumer behavior, including the shift from goods to experiences and the increasing share of e-commerce, which got a boost during the pandemic. Retailers continue to fail and the malls they occupy are dealing with repurposing vacant anchors and inline space. The hit to urban environments in the past 18 months has resulted in rising vacancies in high-street retail, with likely reversal in rent growth in many markets. Conversely, well-located grocery anchored centers and omnichannel-focused big box retailers have survived and, in some cases, thrived. 

Loan underwriters must spend more time than in the past analyzing the creditworthiness of these tenants. The focus should be on changing rent structures; renters are demanding payments based on a percentage of sales, resulting in more uncertain cash flows that are a nightmare for both underwriters and appraisers. 

Hotels: For many types of hospitality properties, performance is springing back faster than most anticipated. Underwriters realize that the safest time to lend is at the bottom of the cycle. Many hotels have been repriced, and those with fresh equity and new marketing strategies can become ideal collateral for commercial mortgages. 

Despite these tailwinds, risks remain. These include the sustainability of the economic recovery through the loan term, labor shortages, and the increasing cost of supplies. Cash flow in business and group travel hotels will likely remain volatile for the next two years and may not yet support permanent debt. At the same time, capital is now available for hotel construction, with completions scheduled for well into the up cycle.

Office: Office has emerged from the pandemic as the big unknown for both equity and debt investors. Many are prognosticating either a return to the office, various hybrid models, or continued work from home, but none can claim to have a crystal ball. Clues as to the unpredictable nature of office demand can be found in the vast sub-let market, reduced demand for space when leases expire, and requests for early lease termination options.

But there will be winners and losers. Newer high-tech buildings in prime locations with strong amenities will attract tenants because they attract their employees. Underwriters need to develop new metrics to assess the creditworthiness of office properties, including a building’s configuration, air systems, carbon footprint, and, of course, the quality of existing tenants and their lease termination schedules during and beyond the term of the debt.

Multi-family: Most multi-family markets performed well during the pandemic, but not all. Estimates showed that more than 20 million Millennials and Gen Z’ers moved in with their parents during the pandemic. Many became used to the comforts of home again, and have less urgency to return to rental properties. Additionally, older Millennials, children in tow, are leaving the apartment market in search of larger homes. On the plus side, Gen Z’ers will be graduating college and starting their careers in greater numbers, and many will likely fill this rental gap. 

Overall, the demographic underpinning multi-family demand won’t be quite as strong in the next decade as it was in the last. With the jury still out on the balance between working from home and in the office, it’s hard to know whether urban or suburban apartments will ultimately win the day. Despite these uncertainties, well-collateralized, well-underwritten multi-family loans provide perhaps the highest-quality credit to lenders of all the asset classes. 

Understanding the Risks
Besides retail, most property sectors and markets had strong fundamentals coming into the pandemic, and loan underwriting was reasonably conservative. While this explains the absence of a robust distressed debt market, which generally follows a downturn, the expiration of bank forbearance agreements at the end of the year will provide a clearer picture of the damage. Those tailwinds and the strong economic recovery should boost property performance in the next few years.

Still, many variables driving risk and return remain uncertain. Liquidity in the commercial real estate debt market has been, and will continue to be, a critical success factor for the many investors seeking relative value in real estate. But those returns now come with the risk of uncertainty, as we discover how demand for all types of space plays out after the pandemic. Measuring, managing, and pricing those risks will likely be an ongoing challenge for the many providers of commercial real estate debt capital.

About EisnerAmper
EisnerAmper LLP, one of the largest professional services firms in the world, is a premier accounting and business advisory services firm with 200 partners and principals, and over 2,000 professionals. The firm provides audit, accounting, and tax services; valuation, due diligence, internal audit and risk management, litigation consulting and forensic accounting; as well as technology, compliance and regulatory, operational consulting, and other professional services to a broad range of clients. 

About Joseph Rubin
Joseph Rubin is currently a consultant to the firm’s Financial Advisory Services Group focusing on real estate clients. Joe has over 35 years of experience in the real estate industry supporting his clients’ most important decisions. He has worked with family-owned businesses, REITs, private equity funds, and financial institutions to develop strategy, improve governance and operations, and manage risk.