What a CMBS Borrower Needs to Contemplate in 2021

When Covid took a firm hold of the world in March 2020 everything came to a standstill. For those not directly impacted health wise by the pandemic, people sheltered in place, ordered in food, and watched untold hours of News, Netflix, and any other movie and tv app they could find. For business owners this period was devastating, not only from the perspective of the health and safety aspect of themselves and their employees, but also how to handle the never-ending flow of expenses and a complete decline of income. As the pandemic raged on, one of the last line items on the owner’s expense list was paying rent for retail centers, and even further down the list was even the thought of business travel to a hotel.

Who can blame them? Throughout 2020 daily newsfeeds showed contamination and death with no clear guidance of when it would be in our cities and what was going to happen to us or to even our most basic resources like grocery supplies. Who would have ever thought that toilet paper could be a used as a gift? (My wife’s friends brought over 2 rolls for her birthday last March, as they sat 10 feet from each other on the driveway drinking wine from their own bottles and wondered if this was the new reality).  Our lifestyles changed overnight from want to need, from travel to shelter and from excessiveness to resourcefulness. For commercial property owners, no business meant no rent and limited, if any, ability to pay debt service. As a CMBS lender for over two decades, I had a front seat to witness the struggles and hard work that owners endured to maintain stability at their properties.

A cumbersome process just got worse

Up to Mid- November of 2020, I was the Southeast Regional Director for a major money center CMBS loan originator. I have been a CMBS lender since the early 1990’s and have seen a few cycles; nothing like this. I spent a majority of 2020 communicating with my banking clients. Discussing the insights from the internal bank meetings and market observations, as well as sharing experiences that my other clients were sharing with me, including loan servicing. This enabled me to have a keen insight into loan performance in the marketplace and provide guidance.

Most clients had difficulties reaching anyone at the loan servicer that they could speak with, and no clear guidance on the proper loan documentation and analysis they should provide to obtain loan relief.  A few of my clients said they had “an in” to the Special Servicer, only to realize that once in Special Servicing the fees were much larger than anticipated and accumulated quickly. What they did not realize that each CMBS securitization has its own Pooling and Servicing Agreement which lays out the rules on decision making between the Master, Special Servicer and Designated Class Holder. Over time, the Loan servicers were able to reorganize their teams, which were also remote, and create a more orderly system to handle the major influx of borrower requests. However, the volume of loan modification and other issues continued to grow. Many Borrowers immediately engaged their counsel to negotiate the business terms of a loan modification which in turn led the Servicer to engage counsel causing further delays and cost in resolving the issues.  

I think we need a translator here

By the third quarter of 2020 I realized that there was an insurmountable communication gap between the Borrower and Servicer, and I formed Brighton Capital Advisors. I put together an experienced team of CMBS bankers, attorneys, special servicers, and underwriters, to assist borrowers in navigating the CMBS process by bridging the communication gap. 

Our first order of business with any advisory client is to see how they are communicating with the loan servicer. Have they submitted a request for modification, have they notified the Servicer of the occurrence of any actions identified in the Loan Agreement that require Lender approval such as, receipt of PPP Funds, Major Lease modifications, or tenant bankruptcies? We have found that keeping the loan servicer apprised of any potential or immanent default and informing them of the strategy to mitigate or cure the default has resulted in the best outcomes.

As the fog dissipates the aftermath is coming into focus

As the weather gets warmer, more vaccines are distributed, easing coronavirus restrictions continue and job gains occur there appears to be a light at the end of the tunnel. Yet, no one really knows how far off that light really is and if there are more pitfalls ahead. Will people be back in offices by year end? Will retail stores be able to gain back lost internet sales? Will business travel recommence? There are many variations of answers to these questions, but one thing is for certain, property income and valuations have eroded.

CoStar tracks the share of transactions selling for the value of land, which is an indicator of distressed asset levels. In a recently published Wealth Management article dated March 29, 2021 Costar currently predicts that about $320 billion in distressed assets will come to market over the next five years, a 60 percent increase over the $192 billion in distressed assets that came to market between 2010 and 2014, following the last recession. Costar estimates $28 billion of those distressed assets will likely be retail assets coming to market in 2021 and 2022 alone, according to Xiaojing Li, managing director with CoStar Risk Analytics. “Based on recent updated economic outlook, with vaccine and $1.9 trillion stimulus in the picture, that predicted number could be revised down, but we still anticipate it could be around or above $20 billion for retail,” he adds.

A pretty good indicator

Noting that the CMBS universe is usually a good indicator of distressed potential, Li notes that, according to CMBS data, retail loans currently represent 28 percent of all outstanding CMBS conduit loan balances and over 40 percent of all delinquent loans. The percentage of retail loans that have been transferred to special servicers is at an all-time high and the percentage of modifications is also higher than the historical average, so the percentage of foreclosures is likely to be lower than the historical average.

Considering that retail represents roughly 20 percent of total commercial real estate market cap and the share of distressed hotels will be disproportionately high and the share of distressed apartment and industrial properties low, Li anticipates that retail will represent 20 to 25 percent of the distressed market.

“I anticipate the wave formation around late 2021 to 2022,” says LI. During the last cycle, the distressed wave peaked in 2010 and 2011, two to three years after the onset of the recession itself. “In general, it takes about nine months for troubled loans to go through the workout phases and enter into the final resolution of note sale or foreclosure, and then roughly another two years to get the liquidation done and transaction closed. I would expect this time it will take longer because lenders and special servicers are more generous on loan modification, extension and forbearance,” Li adds.

TABLE 1: SPECIAL SERVICING RATE BY PROPERTYTYPE CMBS FULL

Source Trepp CMBS Research April 2021

What happens in 2021?

How long will Lenders remain generous? Not long. We anticipate that Lenders will not be as lenient with additional forbearance periods as time moves forward.

According to Trepp, 9.42% of all CMBS loans are in Special Servicing in March 2021 versus 2.83% March 2020. These totals may not include various loans on the servicers Watchlist, Delinquent Loans, Loans under Forbearance or Loan modification requests denied by the servicer. There were $1.13B of CMBS loans transferred to Special Servicing this March compared to $1.19B of loans transferred to Special Servicing in February. As of March 2021, the percentage of Lodging loans is at 24.16% only 1.9% down from 6 months ago, while Retail is at 16.23% only 2.1% down over the same 6-month period. What will the trend be after the forbearance periods end in 2021?

Borrowers should anticipate coming to the table with enough equity to replenish the depleted property reserves, and in some cases paydown loan balances.  However, not all cases are the same. There are many instances that the properties need relief for their tenants to catch up on rent or a replacement tenant to complete upfit. For example, we are currently advising clients on modifying amortizing loans to interest only with the excess cashflow collected by Lender can be utilized for capital improvements which are accretive to the collateral. For Hotels we are working with the Servicers to modify the loan for both temporary monetary relief as well as changes in loan covenants  which allow new preferred equity partners to participate.

The bottom line is that all pre-pandemic loan covenants must be modified to the new post-pandemic reality of property operations. How and when you communicate with the loan servicer can make or break the deal.