Risk management has taken on a whole new meaning during the COVID-19 pandemic. The current economic downturn is unique in that it was triggered by a health crisis, rather than a financial crisis, and hit with different levels of severity. So, the recovery for commercial real estate will be uneven across metro areas and asset classes.
There is no shortage of uncertainty facing the market, most notably how much longer the pandemic will limit economic activity. As such, prudent lenders are ensuring that their underwriting standards are sufficiently rigorous and limit their risk exposure to new and existing commercial mortgages.
It is important for commercial mortgage brokers to understand how lenders are evaluating risk in a market with a post-pandemic recovery path that is largely uncertain. New York City and other major metros were hit harder by the pandemic, and will therefore face a steeper road to recovery than others. Similarly, asset classes such as hospitality and retail bore the brunt of the damage from widespread shelter-in-place measures put in place this past spring, and will recover more slowly than the multifamily and industrial sectors.
Record-high federal aid under the 2020 CARES Act allowed landlords and lenders to avoid a rapid rise in distressed loans and properties. As this aid winds down, however, the market will likely face a reckoning. Borrowers will find it increasingly difficult to collect rent payments from tenants and make their mortgage payments. Another round of relief was approved at the end of 2020 but not at the levels the market saw at the onset of the pandemic.
Although the general principles of risk management remain largely the same today as in past downturns, the need for agility is more pronounced today. The speed with which the market pivoted into recession in the second quarter of last year was unprecedented. As the path to recovery begins to unfold, banks need to respond quickly to a changing market environment.
This requires an understanding of what is going on in local markets, in specific asset classes, and even at the neighborhood and property level. For lenders to manage the current real estate market dynamic, property data will play a pivotal role. As preparation for the next chapter, forward-thinking lenders are already harnessing data in new ways to evaluate their loan portfolios and identify which mortgages are at the highest risk for becoming delinquent. With new originations, lenders are challenged to forecast myriad unknowns. The full impact of the health crisis on occupancy rates, rent projections and valuations have yet to be determined.
Thorough review
Lenders have been taking a fresh look at the risk levels in their loan portfolios. As standard practice, lenders typically categorize their existing loans into low-, medium- and high-risk buckets based on a wide range of variables.
These variables include the borrower’s ability to make loan payments, the type of business operation, property location and asset class. In this way, lenders can gauge how exposed their institution is to nonperforming loans — particularly hotel and retail loans — and take early, proactive steps to minimize losses, including loan sell-offs. One unique aspect of this crisis is that banks have accommodated borrowers and sought to meet them halfway with loan modifications, revised loan terms and payment schedules, forbearances or extensions.
In evaluating proposed loan modifications, responsible lenders have been looking at any other properties owned by the borrower to gauge the overall portfolio risk. Borrowers might ask to bring in additional investors on their loan. If this happens, the lender would tend to review the portfolio of the new investor, too. If other properties in the portfolios of the primary borrower or secondary investor are stable, they could be offered up as collateral.
Banks also are reviewing mortgages on which they are not the sole lender, so they know what percentage of the balance requires approval should the loan need future modification. The bottom line for any lenders assessing their portfolio risks is to know which loans are the most problematic and may require a more urgent response than others.
New originations
Banks are now altering their underwriting practices for new loan requests. Many institutions are taking the risk-averse posture of working only with their existing borrowers. Others are focused on property types perceived as low risk, such as medical facilities, warehouses, distribution centers and suburban offices in certain areas.
Again, data plays an important role. To assess risk on a commercial real estate loan, lenders must ensure their documents are complete and updated. This includes environmental due diligence, the property’s past uses, the planned use of the property, occupancy and rent projections, and the income statements or tax returns for each of the principal owners.
Another important challenge for underwriting today is that the impacts of the pandemic on property valuations are still unknown. Over time, it is likely that prices for certain assets, such as hotels or retail strips, will fall. In a declining price environment, it is critical that borrowers are not taking on properties with adverse conditions, such as environmental contamination. Future problems could adversely affect the asset’s value, or expose the borrower to liability and impact their ability to repay a loan.
Lenders also are routinely assessing the loans in their portfolios for any changes to property or market conditions that could alter a loan’s risk profile. This requires regular reviews to look for red flags and examine property conditions. The obvious data point to follow as an early indicator of where distress may be surfacing is whether tenants are making their rent payments. Although this is a great starting point, there are other steps lenders can take to identify borrowers most at risk.
The easiest step a lender can take is to talk to their borrower. Direct communication is the best source of data available. Lenders are more regularly checking on their borrowers to see how they are doing and to understand what’s going on at their property.
Lenders also are reviewing the borrower against the status of COVID-19 in that region. Are shutdowns lifted? Are infections rising? Mortgages for properties in areas with rising infection rates require more attention than areas where rates are lower. Likewise, loans for properties with operations impacted by the change in seasons may begin to struggle. Summer weather conditions allowed restaurants and stores to transition to outdoor service in virtually all areas of the country. Particularly in northern regions, however, these businesses could struggle through the winter.
Many lenders are taking a good, old-fashioned look at the target property. It could be as straightforward as driving by to see if the tenant on the loan application is actually there.
Property valuations
One of today’s most challenging aspects of commercial mortgage origination may be valuation. Accurately estimating a property’s value is uncertain.
With the number of transactions down, comparable sales aren’t as readily available as they are under healthy market conditions. Prudent lenders are testing assumptions about a property’s accurate value, examining whether rent expectations are reasonable for the property type in a particular location, and judging whether the borrower’s occupancy expectations are reasonable in today’s market.
As they did during the severe downturn a dozen years ago, many lenders are taking a good, old-fashioned look at the target property. It could be as straightforward as driving by to see if the tenant on the loan application is actually there. If not, it’s an obvious red flag for a lender. This was a common tactic for lenders during the Great Recession that is still valuable in today’s dynamic market environment.
Lenders have access to more commercial real estate data than ever before. The challenge is no longer about having enough data. It is about harnessing this data quickly and effectively. Virtually every segment of commercial real estate is impacted by trends that involve new ways of using property data to enable smarter decisionmaking. Risk management is no exception, and banks are getting more sophisticated in efficiently assessing data to mitigate risk exposure at this uncertain stage of the market cycle.
Lenders adopting a data-driven strategy during this time will be able to reduce their risk and maintain a healthy, balanced portfolio without being caught off guard as market sands shift. Challenges from the pandemic will continue to present themselves, but businesses have been able to find ways to operate within the new parameters of this world. By looking to data, lenders can understand what the conditions are like and how to move forward. ●
