Commercial real estate owners sustained a head-on collision with the COVID-19 outbreak in March 2020. The pandemic hammered the bottom lines of many asset classes around the country through the closure of stores, hotels and office buildings. Struggling borrowers quickly reached out to their lenders to obtain relief.
Banks, for the most part, gave borrowers verbal assurances that they would be willing to defer or forbear repayments. But holders of commercial mortgage-backed securities (CMBS) debt were left with few options. CMBS loans, particularly those underpinned by hotels and struggling retail assets, were an immediate casualty of the COVID-19 crisis.
According to Fitch Ratings, the delinquency rates for CMBS hotel and retail loans stood at 17.5% and 11.3%, respectively, as of October 2020. Within the retail sector, regional malls had a delinquency rate of 21%. Some 1,252 CMBS loans totaling $30.1 billion in debt were in special servicing at this time. And, unlike the banks that generally worked with their clients to avoid foreclosure during the early months of the health crisis, some CMBS debt holders had no choice but to walk away from their properties at a steep loss.
CMBS is often viewed as a bellwether for the larger commercial mortgage market as friction and stress are often experienced there first, and the current crisis is no exception. Some analysts believe a similar reckoning will eventually occur for banks. It is important to know, however, that bank loans and CMBS loans have significant differences.
By now, many CMBS borrowers have had a crash course on the inner workings of CMBS and are keenly aware of the differences with traditional loans. But these nuances often are not widely reported and escape the public eye. It is well worth the time of commercial mortgage brokers to gain a sense of what is happening behind the scenes right now in the CMBS world.
The struggles of CMBS borrowers may have a lasting impact on the demand for these loans. According to the Mortgage Bankers Association (MBA), CMBS debt comprised about 14% of the $3.82 trillion in outstanding commercial and multifamily mortgage debt in third-quarter 2020.
As with all loan types, CMBS originations plummeted with the coming of the pandemic. MBA reported a 58% year-over-year decrease for CMBS origination volume in the third quarter of last year, which was second only to the drop in bank portfolio originations. Unlike other investor types, however, it is not as clear that CMBS loan volumes will bounce back as quickly once the pandemic ends. Borrowers have long memories. The CMBS market share fell significantly after the Great Recession and has never recovered. With that said, let’s review some of the key nuances of CMBS that have made relief extremely problematic for borrowers.
Because this relief is short term in nature, must be paid back in its entirety, requires a guarantee and comes with a fairly large price tag, many borrowers are simply concluding that the benefit of taking the relief is not worth the cost.
First, unlike with banks, it is more difficult for CMBS borrowers to negotiate assistance. The decisionmaker for granting relief is not the master servicer or the special servicer but the controlling class representative (CCR) for the CMBS pool that a loan is in. Typically, this is the investor in the most-subordinate bond classes. Borrowers typically cannot speak directly to the CCR, even if they figure out who they are, but they are the party that is essentially pulling the strings.
Another issue with CMBS workouts is that it takes a long time to obtain relief. The approval process lasts three to six months or longer. CMBS servicers are overwhelmed with requests and also are dealing with the inefficiencies created by the health crisis. This is the source of much frustration for borrowers.
Third, all relief is in the form of a deferral. All funds have to be paid back eventually. Nothing is forgiven, and borrowers whose requests are approved will have to pay back the deferred amount typically over a 12-month period starting in 2021 or 2022. For some property types (hotels as a clear example), the asset will likely not generate enough income to make a full debt payment by the end of the relief period. These property owners will be saddled with a regular debt payment and will be required to pay back the deferred amount. This is likely to push many more properties into foreclosure.
In addition to this, special servicers typically require deferred payments to be personally guaranteed, leaving the borrower on the hook for the entire amount. And CMBS relief can be expensive. Special servicers will charge a fee for all loans transferred to them, regardless of whether any relief is actually granted. There are other fees the special servicer will charge upon granting relief and these are typically negotiable.
Furthermore, a condition for many of these relief agreements is for the loan to be placed in cash management. This essentially sweeps up all collected rents and revenues, and places them in an account to service the debt, which is exactly what borrowers are seeking to avoid at all cost.
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Because this relief is short term in nature, must be paid back in its entirety, requires a guarantee and comes with a fairly large price tag, many borrowers are simply concluding that the benefit of taking the relief is not worth the cost. The moral of the story is that CMBS is a highly structured financial instrument and does not work like a traditional loan. When all is going according to plan, CMBS loans are a great lending option. But when things begin to go wrong, CMBS can be a cruel teacher. ●