Current credit trends
Commercial property transaction activity has dropped off in 2020. Dollar volume and transaction count have fallen by 46% and 37%, respectively, through July 2020 when compared to the same period in 2019. But this drop off is not because there is no interested capital. Dry powder allocated to commercial property stood at $147 billion at year end 2019 and close to $24 billion capital has been raised for commercial property in the first half of 2020, per Preqin.
While sidelined cash equity for commercial property is at all time highs, lenders have become more concerned with the current environment and future prospects for commercial property. The importance of debt financing in commercial property markets cannot be understated and has major implications on transaction trends and price discovery. As a result, current lending trends suggest that market activity may remain subdued for quarters to come.
Interest rates are at all time lows, making debt financing attractive for many borrowers. In the past, periods of lower rates have been positively correlated with increased market activity in commercial property and greater price discovery. The low rate environment has enticed many corporate borrowers to take on more debt and lock in cheap financing. Data from the trade group, SIFMA, have shown that corporate debt issuance through the end of July is up nearly 80% over the same period in 2019. However, this data also shows that credit quality is becoming more of the focal point for many lenders – as high yield issuance has seen less than half the increase of investment grade issuance (on percentage basis). Over the same period, commercial mortgage backed securities (CMBS) issuance decreased by nearly a quarter – suggesting less market appetite for commercial property debt.
Despite the attractiveness of low cost debt, availability of credit is not high as lenders shift focus from origination to risk management within their existing book. Lenders are tightening underwriting standards across the board for their loan products. As the Federal Reserve’s most recent Senior Loan Officer Opinion Survey data shows, a significant majority of lenders are tightening standards for corporate borrowers large and small. For commercial property backed loans, lenders are tightening standards for construction loans and non-multifamily (e.g., retail, office, industrial, hotel) even more than they are for loans to businesses. While there appears to be less tightening for multifamily loans relative to other commercial property types, the majority of lenders still expressed greater conservatism going forward. Banks are still lending, but credit is much more constrained than it was at the start of the year and even just a quarter ago.
The key driver of the current credit tightening: uncertainty (duh). While uncertainty is always present, one of the key areas of uncertainty that is decreasing lender comfort levels is uncertainty surrounding the duration of pandemic-related impacts on businesses (e.g., tenants) and introduces a potential demand-side risk for commercial properties going forward. Lenders have not experienced a pandemic-raddled recovery before, so many find it too difficult to confidently assess the current conditions and anticipate the path forward, even for collateral that was viewed as stable less than a year ago. Even the Federal Reserve expressed concerns around their ability to assess the current market conditions in the most recent FOMC minutes: “The staff judged that asset valuation pressures were notable. In particular, high-yield and investment-grade corporate bond spreads were within historical norms, and commercial real estate prices were continuing to increase despite rising vacancy rates.”
The performance of bank’s current loan books has deteriorated some recently, but still sits well below the global financial crisis levels (GFC). Delinquency, non-performing, and chargeoff rates are likely to increase in the coming quarters; but barring another major shock (e.g., massive spike in cases, negative set back in vaccine / therapeutic treatment development, reversal of recovery), these rates will likely remain below the levels of the prior crisis.
Even months past the initial shock that hit so many businesses hard, many management teams remain wary and have decreased confidence. The vast majority of businesses continue to be negatively impacted by the health crisis, per Census Bureau’s Small Business Pulse survey. While the percentage of respondents who have been negatively impacted has fallen since May when the weekly survey was first launched, the most recent release still shows that over 70% of small businesses have experienced a negative hit to business. This is illustrative of the increased tenant risk that commercial property owners face and it also raises valuation questions about commercial properties. Many of these valuation concerns are highlighted by the publicly traded real estate investment trust (REIT) declines. Per NAREIT data, with the exception of industrial properties, REITs holding the other major property types have shed between a quarter to half of their value in 2020.
Making it actionable
Understanding the broad market trends is important and can better inform actions. There are a number of implications one can draw from the current trends to bring it closer to home. The fact that lenders are tightening standards suggests that if you are looking to refinance or secure debt financing for a property, property operating and performance history is likely more important than ever. One can expect to see lower LTV’s, higher DSCR’s, fewer exceptions granted, more conditions, and overall less borrower flexibility. Smaller lenders (e.g., community banks, non-bank lenders) may provide greater flexibility in negotiable loan terms.
It is also important to note that even though there has been limited market activity to support price discovery, valuations can change. Look at the tenant exposure of properties to see how the business risk of the tenant might reflect on the property valuation. Additionally, properties that may be most noticeably and negatively affected are those which are located in markets that have seen recent rapid pre-pandemic price growth. Expect to see high single- to low double-digit haircuts applied to pre-pandemic trades if no better comparable sales are available. Two key potential borrower groups likely to be most affected by the current constricted credit conditions and uncertainty surrounding valuation assessments are current property owners needing to refinance in the coming quarters and investors who are looking to enter the market.