While some lenders have taken a step back from originating new deals, others have started to readjust their underwriting strategies and are moving forward amid the ongoing economic crisis. And although past downturns may offer some direction and a potential timeline for recovery, it is certain that both lenders and borrowers are faced with unprecedented circumstances.
Patrick Ward, founder & president of MetroGroup Realty Finance, spoke to Commercial Property Executive about the current sentiment in the financial industry. What is the best approach in these uncertain times and what can industry players expect going forward? Ward shares his insight in the interview below.
READ ALSO: NAIOP Finds Drop in CRE Confidence
What is your take on the current capital market environment?
Ward: The Fed has made several moves over the last few weeks to maintain economic stability. In an unprecedented move, the Fed is also lending money to issuers of corporate debt, municipal governments and directly to businesses. This Fed involvement should bring assurances to the capital markets, which will bring back the past stability for lending on commercial properties.
Despite the recent reduction in interest rates, the cost of capital has actually increased as a result of the uncertainty surrounding COVID-19 in the current environment. In fact, this uncertainty and lack of liquidity drove the CMBS segment out of the market and created uncertainty on pricing with others. Rightfully so, lenders are concerned about the performance of income properties, as it relates to tenants’ ability to pay rent during this unique time.
Prior to the effects of COVID-19, available capital secured by real estate was predominantly in the low 3 percent range, selectively even below 3 percent, at 2.8 to 2.9 percent for 10-year termed mortgages. Currently, we see 10-year rates, at best, in the mid 3s, with most of the lenders in the high 3s and low 4s for 10-year fixed-rate terms. This is approximately 75 basis points higher than before COVID-19.
How are lenders and borrowers faring amid the ongoing uncertainty?
Ward: Lenders are being careful and closely analyzing rent rolls, as well as properties’ anticipated future performance based on the tenants’ position in the current climate. Some tenants are directly and dramatically affected by consumers staying home, where others may be less impacted. This, combined with a slight increase in the cost of capital, is making both lenders and borrowers careful.
That said, we just issued an application for a single-tenant, credit retail facility in Inyo County, Calif., fixed at 3.5 percent for 10 years. We are in final discussions to provide a loan on a building occupied by a single-tenant, noncredit local company in Montclair, Calif., at 4 percent for a 10-year term. We are seeing the lending community asses and adjust to the effects of the COVID-19 pandemic on commercial real estate. We are seeing rates settle back down approximately 50 basis points, as well as lender confidence in the future performance of most asset classes.
What can lenders and borrowers do to better manage the crisis?
Ward: Excellent communication and responsible interaction are crucial for both lenders and borrowers in the current environment. In doing so, they can work with clients or tenants to work through challenges properties may be facing. From a lender’s perspective, many lenders gained valuable experience working with clients during the 2008 financial crisis and are applying those tools again today. For example, in the 2008 crisis, lenders were more patient with borrowers and kept an open stream of communication in giving them time to work out issues either through mortgage payment reductions or deferrals.
Naturally, certain asset classes in the lenders’ portfolio are positioned to perform better than others in the next several months and maybe years. The lenders with more stringent underwriting practices, credit quality and liquidity requirements will obviously fare better than those that needed to be aggressive to make their mortgage investments. The more conservative lenders only lent to applicants with the resources and liquidity to navigate through a difficult time, as we are in now. Borrowers are in a similar position as their lenders. They are working with responsive and deserving tenants to give them time to work through and navigate this situation together. Some of our retail developers are reporting collecting only 40 to 50 percent of their rent in April and are expecting May to be worse.
Are some types of lenders more susceptible to the pandemic?
Ward: The CMBS market has been the most impacted by the pandemic. Over the last 10 years, CMBS lenders have placed a majority of the hospitality loans we see in the market today. They will continue to show delinquencies and poor performance until the hospitality sector can rebound. The current distribution of commercial property loans is as follows—banks (39 percent), agency (20 percent), life insurance companies (15 percent), CMBS (14 percent) and others (12 percent).
The segment least affected will likely be life insurance companies. Historically, these lenders have been the most conservative in their investment criteria and underwriting. In all capital classes, there are lenders exclusively concentrating on the health of their existing portfolios and are temporarily out of the origination market. Some are in the market in a passive way and some are surprisingly aggressive, as mentioned above where we issued an application in the 3.25 percent range for a 10-year term.
How do current circumstances compare to 2008?
Ward: This financing landscape does have some similarities to the 2008 financial downturn. However, the cause of the current crisis is dramatically different, which cannot be ignored. The 2008 financial crisis started in the real estate sector and lasted approximately 42 months. During this time, there was a complete lack of liquidity. The current environment was not a result of the real estate market, and prior to the pandemic, real estate fundamentals were exceptionally strong. We see the COVID-19 pandemic’s effect on the capital markets as less dramatic and for a much shorter period of time.
How is your company navigating current events?
Ward: We work with a variety of different classes of capital sources. The only class of lenders where there is total uniformity is in the CMBS arena. CMBS has been completely priced out of the market as a result of liquidity. There has been no confidence from investors in the higher risk portion of the pools. That said, we have recently begun to see signs of improvement and expect it to be back in as soon as 60-to-90 days.
Since our inception in 1983, we have seen several economic cycles all caused by different specific events. In the current environment, there have certainly been many people affected, whether it is job loss, business loss, etc. While some may not fully recover, most of the capital sources we work with are of the opinion that this will not be as deep or last as long as other cycles. At MetroGroup, we have a few assignments that are getting delayed and may get restructured, but not denied. However, for the most part, we see good velocity and activity. From the lending perspective, we see the majority of capital sources still considering mortgage loans on commercial property to be a good allocation of their investment portfolio.
What is your mid- and long-term prognosis for the U.S. finance sector?
Ward: We believe that the current disruption of capital to commercial real estate is a short-term event that was a result of the pandemic, and the government mandate to close schools and non-essential businesses and enforce stay-at-home and social-distancing orders. Once the effects of COVID-19 are behind us, normal activity should resume within a reasonable period of time.
Lenders will then feel more comfortable continuing to make loans on income properties. The lending community has always looked at mortgage investments with a long-term perspective. In this case, they see our current environment as something that will ultimately heal itself, allowing properties to return back to pre-pandemic performance. Mortgage investments for portfolio lenders, large banks and life insurance companies have always been an attractive source of investment. With the expected recovery of the CMBS market, there should continue to be ample reasonably priced capital to provide mortgage loans secured by income properties.