For the first time in history, the world has voluntarily, simultaneously slammed the brakes on the giant economic train that we have created over the last few centuries. Businesses are closed, public places are off-limits and millions upon millions have been ordered to stay at home. The good news is, this seems to be working to help our medical system deal with the coronavirus we have all come to know as COVID-19. The bad news is, while we have demonstrated that we can stop the engine of the train, you can’t do the same with the other train cars that are lashed behind it. If this temporary stoppage goes on too long, we risk seeing the world’s financial baggage, unable to break under its momentum, come crashing into us, sending us into a financial crisis that would cause widespread recessions and all of the suffering that goes with them.
Most of the property industry has already realized that many rents will not be paid. Both residential and commercial renters are facing a cash crunch, many will not be able to pay their rents. Already it is reported that around one-third of residential renters did not pay April rent and corporate tenants like Cheesecake Factory, Equinox and even WeWork have already told landlords that they will not be making rent payments on some or all of their locations, some using “force majeure” as a reason to renegotiate payment terms or break their leases altogether. Landlords are finding creative ways to help their tenants get through the shutdown, such as what is called a “blend and extend” lease alteration that gives a temporary rent holiday and amortizes the unpaid rent over the rest of the lease term. But these creative solutions are only going to help soften the blow, not stop it, especially because commercial buildings are valued by their cash flow, which has been disrupted if not reduced.
Governments around the world understand the imminent threat that this shutdown poses to our property values and therefore our financial systems and economic future. In the U.S. the federal government created a record $2 trillion financial stimulus package that includes universal payments to low-income citizens, loans to corporations, and new regulations that allow for mortgage forbearance and prohibit evictions. These measures included $100 billion to a program called Term Asset-Backed Securities Loan Facility of TALF. This organization was created in the wake of the great recession where it is largely seen to have helped bring stability back after the collapse of credit markets due to the (over) securitization of mortgages. Last month TALF was refunded and given the mission to “serve as a funding backstop to facilitate the issuance of eligible ABS on or after March 23, 2020.” This means that any new loans will not be covered by the program but that, just as we are learning with nearly everything in our lives, is subject to change.
But there were limitations to who was eligible for TALF. Initially, the relief loans were only being issued to “agency” CMBS, in other words, those purchased by Fannie Mae and FreddieMac. While this makes up a large part of the residential multi-family mortgage bonds, it is only a part of the commercial lending landscape. Only providing support for certain types of real estate debt securities threatened to hurt the valuations of millions of commercial properties and put a strain on the commercial mortgage market. The uncertainty has put downward pressure on the future profitability, and therefore present value, of the majority of buildings in the country.
The stress fractures of this strain showed first in the commercial mortgage spreads, the difference between what the base index rate, which is at an all-time low, and the spread that lenders actually were willing to fund loans at. I talked to Constantine Korologos, Clinical Assistant Professor of Real Estate at the NYU Schack Institute about this. Constantine, he goes by Tino, knows a thing or two about mortgage backed security volatility. He previously worked as a managing director for Deloitte Financial Advisory Services. “My first day was on September 15th 2008, Lehman Monday,” he said with the kind of laugh that comes with remembering past anguish. “I showed up to work and saw every dashboard in the market going crazy. But even then we didn’t see as wild of swings in Triple-A rated CMBS spreads over the ten-year swap. In the midst of the pandemic fears, it was as much as 300 basis points,” he said.
Just to step back a bit, commercial lenders sometimes use the treasury swap rates similar to an index. The Ten-year Treasury Swap tends to be an accurate reflection of the open market’s expectations for future treasury rates. Treasury bonds that mature in ten years, generally are thought to be one of the safest places to put money. A basis point is one one-hundredth of a percent, so three hundred basis points is three full percentage points. The fact that lending spreads are measured in basis points shows how small the changes in these spreads usually tend to be, that they are measured in a metric that is orders of magnitude smaller than what we are seeing now. “In the beginning of the year we were dealing with around 10 year AAA CMBS spreads of 78 basis points over the ten-year swap, so we saw them more than triple,” Tino said to give some context.
The quick rise in CMBS spreads had everything to do with risk. Lenders were worried about commercial mortgages, which could see defaults due to lack of rent payment and didn’t have the same kind of protections as residential counterparts. Fannie and Freddy do participate in the CMBS market, they have become one of the biggest purchasers of multifamily loans since TALF started, but that only makes up about one-tenth of the entire commercial lending securities landscape. This would leave most lenders and CMBS investors would be exposed to the impending loss of property value.
Now, as of April 9th, the stimulus plan received another $2.4 trillion in funding to help lending markets. In addition to all of this extra “dry powder,” TALF has been expanded to include the highest-rated asset backed securities including RMBS and CMBS bonds. With the Fed providing liquidity for these bonds though holding them on its balance sheet, the thought is that commercial mortgage backed securities will have more market price discovery, and hopefully less volatility, at least through what we all hope is a temporary crisis. But while CMBS loans are a good proxy for investor sentiment in a world where very few new loans are being originated and therefore no firm market prices are being set, it is only a fraction of the entire commercial mortgage supply. “The CMBS market represents less than 15 percent of the total outstanding commercial debt,” Tino said. “Banks hold around 40 percent, government agencies around 20 percent and life insurance companies hold around 15 percent. It is the 40 percent of commercial mortgages held by federally regulated banks, with a 2019 year end balance of around $1.4 trillion, that could represent a massive problem. Those banks will have to face challenges and we don’t know yet if they will be able to withstand this value drop from market stress or if we will see bankruptcies and bailouts like we did in 2008.”
When the markets open on Monday we will see how this increased fiscal stimulus affects the CMBS market, but it might be months before we fully understand what happens to commercial lending in a broader sense. The fact of the matter still stands that very little debt is being originated. Hundreds of millions of dollars of loans are due, that if not temporarily modified or restructured, will have to be refinanced in a turbulent, uncertain market. One of the things that might help our healthcare system catch up to the virus and give us time for the economic strain to start its slow restart. According to Jeff Friedman, shareholder at the law firm Hall Estill, “The good news for CMBS borrowers is that servicers and special servicers, those third parties charged with servicing CMBS loans in distress, are painfully slow to act when times are good. So, when the entire market is under such extreme stress, those servicers will be underwater for some time just playing triage.”
