The Possible Long-Term Effects of COVID-19 on the CRE Loan Market
Low interest rates may not insulate the commercial real estate industry and its financial partners against the lasting challenges of COVID-19
- The COVID-19 economic downturn quickly affected CRE
- Capital may be cheap, but obtaining it is not necessarily easy
- Pre-pandemic, analysts projected CRE would experience steady growth
- Late-2020 events have spurred some revised, negative outlooks
- Decision-makers are proceeding with caution in the uncertain economic and political climate
The CRE industry felt the impact of COVID-19 almost immediately. But historically, CRE is not the canary in the coal mine: it has traditionally been much slower than other sectors to react to economic downturns. This is yet another norm upended by the virus.
When financial markets declined in March 2020 after the virus was declared a pandemic, leasing volumes also sharply decreased, as did the number of CRE loans issued. Existing tenants quickly had trouble making rent: shopping center REITs reported receiving only 46% of their typical rent as early as April. In 2020, the Manhattan office leasing market had its worst quarter since 2013, as many corporations scaled back their office space and renegotiated or canceled their leases.
The overall CRE market continues to struggle because many of its highest-value tenants are in the hardest-hit sectors—sectors that are slowest to show signs of a rebound: hospitality, retail, travel, and entertainment.
The excitement generated by low interest rates and government stimulus payments is offset by some harsh market realities. Instead of a firehose of “cheap money,” industry watchers have predicted an increasing spread between U.S. Treasury rates and average CRE rates. Because of uncertainty in the market and fears of an extended recession, lenders are raising their rates or very closely scrutinizing potential loans.
While capital may be cheaper, access to it is not necessarily easy.
Looking back: Industry conditions pre-pandemic
Before the pandemic, the CRE industry was in much better financial shape than before the 2008 recession. Recovery from 2009 yielded the longest bull market in history. Balance sheets were healthy and capital was readily available, putting CRE in a strong position heading into 2020.
Financial forecasters predicted steady growth in the CRE market, even with a presumed rise in interest rates. Numerous analysts assessed that the “retail apocalypse” would subside in 2020, with positive implications for commercial landlords. Many believed the multifamily and apartment sectors would be impacted by the trend of rent control legislation in many states, but it was too early to gauge the effect.
A softening was projected in some sectors, such as REITs and retail. Regardless, many experts predicted the loan market would grow by five percent.
The lessons of the 2008 financial crisis resulted in new safeguards to prevent a similar systemic meltdown. But no preventative measures would have been prescient enough to counter the economic upheaval caused by COVID-19.
COVID-19’s continuing impact
The pandemic did not fuel a conventional economic downturn with a predictable recovery arc—we are, as has been repeatedly noted, in “unprecedented times.” Financial experts who were cautiously optimistic last August have adjusted their tone on the heels of disappointing news:
- The Mortgage Bankers Association reported an increase in delinquency rates for mortgages backed by commercial and multifamily properties for the second month in a row in December 2020.
- Moody’s reported a huge spike in the delinquency rates of commercial mortgage-backed securities (CMBS) in the second quarter of 2020 (5.5%, up 3% from 2020 Q1).
- 20 large real estate companies, two of which own more than $50 million in assets, have filed bankruptcy by December 2020 (reported by Bloomberg).
- CoStar, a CRE information and analytics provider, recently estimated that $126 billion in commercial real estate will be forced to sell at distressed prices through 2022.
- U.S. office leasing in January 2021 was down 44% from the previous year’s total.
There are some encouraging reports, however: specific sectors of the CRE market (industrial properties, distribution centers, cold storage facilities, and niche properties such as biolabs) showed signs of steady growth in 2020.
The CRE industry’s post-pandemic future
It remains difficult to project the post-pandemic future of CRE and its financial infrastructure. The U.S. economic recovery and the industry’s ability to rebound will largely depend on the distribution and effectiveness of a vaccine.
Leaders of companies in the CRE industry have expressed their concerns about the economic climate, and many are proceeding with excess caution when taking on new debt. Decisionmakers are balancing the need for cost containment with making necessary investments in their existing properties.
Going forward, it is expected that lenders will structure deals and offer credit to commercial borrowers in more risk-averse ways as loan delinquencies increase. A tightened access to capital will likely significantly affect the CRE sectors slowest to recover, like hospitality and office leasing. The transfer of power in Washington D.C. adds another layer of uncertainty, as the Biden administration may push for increased regulatory oversight or roll back recent directives.
The CRE industry and the financial and legal institutions that support it can’t assume business will quickly return to pre-pandemic normalcy. Continued volatility may be in the cards for some time.
The attorneys at Johnston Clem Gifford routinely advise commercial and retail banks, credit unions, hedge funds, REITs, consumer finance lenders, insurers, and secured and unsecured creditors of all kinds on distressed debt and bankruptcy issues. Contact us online or by calling (214) 974-8000.