Against the current backdrop, forbearance is the most sensible route for lenders to consider.
Healthy Real Estate Fundamentals Heading into this Market Shock
The commercial real estate market, while late cycle, was healthy coming into this recent pandemic crisis. While there were pockets of concern around certain asset classes and metropolitan statistical areas (MSAs), there was not a significant mismatch between supply and demand. In the past crisis, real estate defaults always lagged behind the general financial markets. As of now, it appears this market will not be different save for one exception. The current real estate market is seeing a wave of forbearance requests.
What is Forbearance?
Forbearance is not a new concept and is arguably mainstream given our country’s unfortunate recent run of natural disasters. When borrowers are unable to make their required loan payment, lenders will sometimes arrange a special agreement designed to help avoid a foreclosure. This special agreement is referred to as forbearance. Forbearance is typically granted when a borrower’s inability to repay their loan is deemed temporary.
Nuances of Forbearance in the Commercial Real Estate Market
Most headlines regarding forbearance are in reference to the residential mortgage market where the COVID-19 forbearance guidance that was previously announced by HUD and the FHFA was codified in the CARES Act. Many residential mortgages are federally backed and the CARES Act went so far as to require the governmentsponsored enterprises (Fannie Mae and Freddie Mac) to grant forbearance.
In the commercial real estate market, the onus is on lenders to determine how and when to effectively apply forbearance.
In the commercial real estate market, with the exception of federally backed loans in the multi-family space, the vast majority of loans are privately negotiated between two parties and the federally required forbearance does not formally apply. However, that does not stop borrowers in the commercial real estate market from requesting forbearance, and the forbearance guidance outlined by the Federal Reserve and FHFA has set the stage for the other commercial lending segments to follow suit.
To be clear, forbearance is not inherently bad for commercial real estate lenders. That said, the onus is on lenders to determine how and when to effectively apply forbearance, and there are several dynamics in the current market environment that make forbearance the most attractive option for lenders.
Why this Cycle is Different – Understanding the Impact of COVID-19
While loan forbearance is not new in the commercial real estate market, it was never used to this degree. When problems occur at properties over the course of a typical real estate cycle, borrowers usually turn to lenders and seek some form of aid. Under normal circumstances, lenders evaluate how much, if any, assistance to provide based on the value the borrower adds to the property. For example, lenders will usually accommodate borrowers who have more capital to invest in the property or possess expertise that would help stabilize the property and make the loan viable. If borrowers do not demonstrate any discernible value, foreclosure is typically the most effective option for lenders seeking to preserve cash flow and maintain the value of the property.
However, due to the impact of the COVID-19 pandemic, foreclosure is not a possibility or even a viable option in the current commercial real estate market for two reasons:
1. Court houses are closed and there is no ability to start a foreclosure action.
2. The market decline was so sharp and fast that in many cases, there is no value or cash flow to protect, which makes forbearance the best option for lenders.
In addition, when courts eventually reopen, the volume of legal proceedings is expected to be extremely high. Current circumstances are always considered when foreclosure or bankruptcy proceedings are initiated, which means the impact of the COVID-19 pandemic will likely lead most judges to question what value there is for the lender to protect. Against this backdrop, forbearance is the most sensible route for lenders to consider.
Voya’s Approach to Forbearance
A forbearance can be structured in different ways. For example, the borrower can stop paying both principal and interest payments or make interest-only payments. The borrower is then required to pay back the part of the loan, which was deferred over an agreed-upon time frame. This repayment time period could be over 12 months or even at the end of the loan term. We require the property be placed into some form of cash management to ensure any excess cash flow goes into the property, therefore, preventing borrowers from distributing funds to their partners.
Amid the challenging market backdrop, we have tried to target borrowers who need assistance the most. Upon a forbearance request, we seek to get current borrower financials, legal deposit, and a legal agreement to start the process. Borrowers that needed help engaged us immediately, while others felt the associated legal costs with forbearance outweighed their need to request it.
We Are Prepared for Multiple Waves of Forbearance Requests
The degree of forbearance requests is expected to vary by asset class and region, and we are preparing for the potential that forbearance requests come in waves based on the length of this crisis.
The overarching goal is to provide needed relief that supports the valuation and stability of the collateral.
As we would expect, the first wave of forbearance requests was driven by borrowers at properties where there was a significant shortfall in rent payments. However, there also appears to be an opportunistic element in the first wave of forbearance requests. In some cases, the application for forbearance was dropped because rent collections turned out to be sufficient, or borrowers did not want to start the legal process. Effectively, some borrowers knew lenders would be overwhelmed and wanted to get in the queue first or were not sure what April rent collections would look like. As a result, some forbearance requests were rescinded once the borrowers realized they had enough cash to make the payment.
From a geographic basis, more applications came from California and the northeast, which is not surprising since these were the markets initially impacted by shelter in place orders. Across property types, we will continue to focus on borrowers that need the most help, and structure agreements that best protect the collateral. The overarching goal is to provide needed relief to support the valuation and stability of the collateral. The following sections provide more detail on the idiosyncrasies of each asset class in the commercial real estate universe.
As with any previous financial crisis, the hotel industry is typically the first to face stress, and this time is no exception. As expected, the first forbearance requests we received (in late March) were primarily from hotels. As the pandemic took hold, the first impact on commerce was to business and leisure travel, immediately affecting hotels. An average hotel occupancy rate runs 70%, and we saw hotel occupancies drop to 20% and below. Hotel properties carry significant operational leverage, meaning no matter what the occupancy of the hotel, the operational costs stay high. Therefore, many hotel operators have decided to “mothball” the properties for the duration of the crisis.
Hotels represent a tiny percentage of Voya’s overall commercial real estate loan portfolio, which means our exposure to this troubled property type is relatively small.
Even when the hotels come back online, the average daily rate (ADR) will most likely take some time to rebound, meaning net operating income will stay low for the remainder of 2020 and beyond. In the hotel industry, forbearance periods will need to be relatively longer to allow borrowers enough time to regain their ability to cover debt service payments.
Hotels in drivable vacation destinations are likely to see guests earlier in the recovery as families look forward to getting out once permitted and safe. Hotels that rely more on air-travel guests (including leisure and business) are more likely to be the next segment. However, the timing will depend on how soon nonessential domestic air travel returns to normal. The conference segment is expected to be the last to recover, or would require both more normalized air travel and relaxed standards around social distancing. Overall, average daily rates could take up to three years to recover to pre-COVID levels.
Hotels represent a tiny portion of Voya’s overall commercial real estate loan portfolio. This means that our exposure to this troubled property type is relatively small.
The second wave of forbearance requests we have received are mostly from borrowers at retail properties. Many retail owners have moved to a tenancy that is less impacted by competition from online sales, including restaurants, nail salons, yoga studios, and work-out facilities. In many jurisdictions, these retail uses are not deemed essential or could not comply with social distancing rules and therefore, have been shut down. Retail operators are looking to give their tenants rent relief, hoping they can survive the short-term stress and remain viable over the long run. Their overarching goal is to try to keep these tenants in place as long as possible. They are making the call that it will be cheaper to make a rent concession now than have to pay for new leasing commissions and tenant improvements if their current tenants fail.
We have received forbearance requests for multi-family properties but not anywhere near the level of forbearance requests we received in the retail and hospitality asset classes. It is possible that as jobless claims increase, the next wave of forbearance requests will be in multi-family. We believe the highest risk properties are the Class A multi-family properties. They saw the most significant rent increases over this cycle, making the rents hard to afford in good times and impossible in bad times. Class A properties will likely see rent decreases and higher vacancies.
While Class B properties will come under strain from mounting unemployment, these properties should also benefit from a wave of new tenants who can no longer afford the Class A segment of the market.
The majority of our multi-family portfolio is represented by Class B multi-family or “workforce housing.” Workforce housing, while affordable, may see some stress as job losses mount. However, they should also benefit from a wave of new tenants who can no longer afford the Class A segment of the market. The majority of borrowers who rescinded their forbearance requests were multi-family owners. This was due to higher-than-expected rent collection levels for April.
Office and Industrial
We received minimal requests in the office and industrial asset classes. Office properties may see some stress in reduced rent payments due to tenants having financial hardship issues or if the tenants are blocked from the building due to government mandate. In the latter case, tenants are arguing that without access to their space, Why should they have to pay rent? Although there is potential for office properties to see some stress. We do not expect it will be to the level that hotel and retail assets are facing. Finally, industrial (and the industrial subset selfstorage) is seeing little, if any, problems. By no means is this asset class insulated from general economic downturns, but for now, this area of the real estate market is performing well.
Production Outlook: Pockets of Opportunity
We are finding the most compelling opportunities where other lenders have walked away from loans and the borrowers need capital. Typically, these situations are near-term debt maturities where the existing lender has not extended the loan, or a property acquisition that is moving forward with closing in the near term. We are re-underwriting deals with the view of nearterm weakness and a more negative long-term view of valuations and cash flow. If these deals meet this hurdle and the wider pricing is acceptable to the borrower given the limited choices, we are willing to sign up a loan.
Our outlook for hotels and many areas of the retail market is negative. Our outlook is increasingly conservative for the multi-family market given the near-term disruption in rental payments and the longer-term impact that a recession will have on affordability and demand from tenants. Office properties will be challenged in this environment, but if underwritten properly, opportunities may present themselves. Finally, industrial property performance should weaken and rents could be impacted, but attractive opportunities are likely.
Past performance does not guarantee future results. This commentary has been prepared by Voya Investment Management for informational purposes. Nothing contained herein should be construed as (i) an offer to sell or solicitation of an offer to buy any security or (ii) a recommendation as to the advisability of investing in, purchasing or selling any security. Any opinions expressed herein reflect our judgment and are subject to change. Certain of the statements contained herein are statements of future expectations and other forward-looking statements that are based on management’s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. Actual results, performance or events may differ materially from those in such statements due to, without limitation, (1) general economic conditions, (2) performance of financial markets, (3) interest rate levels, (4) increasing levels of loan defaults, (5) changes in laws and regulations, and (6) changes in the policies of governments and/or regulatory authorities.