COVID-19’s impact and economic fallout has been exceptionally widespread, collecting a menagerie of victims in its wake. Of the casualties, Commercial Real Estate stands as a particularly aggrieved party.
- Collapse of small businesses
- Supply chain disruptions
- Space demand destruction
- Loss of consumer confidence
- Rapidly changing market conditions
- Sector upsets in hospitality, office, restaurant, entertainment & construction
Not last, and certainly not least (as the above list could go on), is the topic of extended forbearance and the CRE landscape thereafter. As we enter May and June we are fast approaching the expiry date of a large percentage of CRE forbearances. So the pressing question becomes what happens when these expire?
For federally backed loans, that question was recently answered February 16th with the Biden Administration’s announcement: more forbearance.
But for private banks and loan servicers, the future is still unknown. It’s essentially a zero-sum game for loan servicers and borrowers; more forbearance benefits borrowers in the short term to the detriment of loan servicers. However, the longer this goes on, the harder it will be for borrowers to pay the ever-increasing lump sum at the end of the forbearance period.
CRE Landscape 2021
- A 2020 US Congressional Research Service report estimated the total size of US commercial real estate to be $16 trillion, with $3 trillion in outstanding debt.
- 2021 CRE market size, measured by revenue, is $893.2 billion – IBISWorld
- The number of active business owners in the United States plummeted by 3.3 million or 22% over the crucial 2‐month window from February to April 2020 – NCBI
- 50% of all small businesses in the US have closed due to the pandemic’s economic impact & 1.8% closed permanently – PNAS
A record number of forbearances originated in 2020, the overwhelming majority of which are still in some form of forbearance over 12 months after the emergency installment of the policies and initiatives that support them. These loans are fast approaching the forbearance period’s expiry date. The effect of the pandemic on small businesses is especially troubling for commercial real estate as these businesses are often tenants of larger enterprises which could indicate the need for intense loss mitigation measures for lenders in the near future.
The impact of the pandemic is resulting in substantial changes to the CRE hospitality, retail office, entertainment, and construction sectors. Many restaurants and storefronts have closed down or opened on a limited basis, travel is limited which depresses tourism and hotel/resort revenue, a growing number of offices are becoming vacant and entertainment stadiums and arenas are left without the bustling crowds as tours and seasons are canceled or mellowed. Commercial tenants throughout the US are going out of business, temporarily closing, curtailing operations, laying off employees, and suffering sharply declining revenues; this will massively affect the lenders and loan servicers that support commercial enterprise.
Traditionally, it is expected that a borrower repays a forborne amount in a lump sum at the end of the forbearance period or enters into some form of loss mitigation. While it is beneficial in the short term to the borrower, the longer the forbearance period the more difficult it becomes for the borrower to pay off the forborne amount. In spite of the anticipated recovery in the economy, many small businesses will be hard-pressed to make up for the losses sustained over multiple lockdowns and pandemic operation restrictions, making it difficult to provide lump-sum payment. Considering the current mortgage landscape and unemployment rate, it is probable that a significant portion of loans currently in forbearance may ultimately default.
Lenders need to have clear plans for this transition, focusing on flexibility, communication, and loss mitigation strategy. In light of market developments concerning space demand and the fall of offices and brick & mortar stores, lenders should prioritize refinancing options and payment plans. Suppose functional programs are in place that provides for borrowers to defer payment on forborne amounts or to refinance. In that case, the borrower’s financial burden is decreased, making it easier for them to restart mortgage payments without significantly increased financial burden.
With the current state of space demand destruction, especially in urban areas, foreclosures might be even more costly, as they risk lenders becoming owners/operators of underperforming assets that are becoming outdated in the marketplace.
Using the 2008 depression as historical context, commercial real estate investors should adopt greater flexibility & patience into their operating models. As with most things post-covid, flexibility will remain key in navigating the post forbearance landscape. Additional forms of payment deferral or likewise may be a difficult pill to swallow, but lenders may have to just grin and bear it for the short term.