CMBS Rebound Continues, With Retail Loans Leading the Way

Lenders are making headway working out troubled loans, especially on retail properties. Delinquency rates in commercial mortgage-backed securities (CMBS) declined 23 basis points in March to 4.10 percent, from 4.33 percent the previous month, according to Fitch Ratings.

The rating agency said $1.6 billion in loans were resolved in March, focused mainly on retail assets. Loans totaling $951 million on eight regional malls -- from New Jersey to Hawaii – were resolved, including a $256 million loan on a mall in the Midwest. Fitch said two of the mall loans were modified; five were resolved through the reapplication of funds for debt service; and in one case, the sponsor funded shortfalls.

Meanwhile, the pace of new delinquencies slowed to the lowest rate since the beginning of the pandemic, and new issuances are robust, Fitch reported. Curt Spaugh, a SitusAMC Senior Director focused on special servicing, says while trendlines are positive, certain sectors continue to face structural challenges.

Regional retail malls made up the bulk of CMBS resolutions last month. Does that indicate that the market is out of the woods?

I don’t think we’re quite out of the woods yet. Retail was struggling even before the pandemic, especially large indoor malls. Before the pandemic, retail developers and owners tried to counter the online shopping phenomenon by making malls a leisure destination, with entertainment, restaurants and activities, and adding areas where people can socialize and kids can play. During the pandemic, however, these were shut down. Even as things open back up, COVID has only accelerated the use of online shopping, so those challenges will continue.

One of the largest resolutions reported by Fitch was a mall loan that was transferred to special servicing back in June 2020. It was recently converted to interest-only for the remainder of the term, and principal and interest payments were deferred through February 2021. The deferred amount is to be repaid by March 2023. Are these typical of the workout terms you’ve been seeing in the market?

Yes, relatively minor payment deferrals have been quite common. Determining the best workout strategy really depends on a number of factors. When we have a defaulted loan that hits our desk, one of the first questions is, what caused the default? Is the borrower part of the problem, or could they be part of the solution? As a special servicer, our job is to maximize the recovery and minimize our losses using our entire toolbox. Those tools could be modifying the loan, or selling the loan, or foreclosing. We look for win-win resolutions, but at the end of the day have to do what’s best for the bond holders.

Some problems are beyond anyone’s control. We had a lot of good borrowers that were forced to close their properties due to state, county and city orders during the pandemic. In cases where we see light at the end of the tunnel or a rebound coming, we typically worked out loan modifications with experienced borrowers and operators.   

What strategies have been most successful?

We’ve had good luck with a restructured finance strategy known as an “A/B hope note,” which is based on the hope that the asset value will increase over time.  Generally speaking, the lender bifurcates the loan with the A Note approximating the current value of the collateral in exchange for a new capital investment by the borrower. The B-Note is ultimately paid by a percentage of the upside value, if any, when the property is sold. These were widely used during the Great Recession.

In a down market, where there is some upside with the borrower, a hope note can help maximize the recovery for bond holders. On the other hand, sometimes there is no workout. You might have a bad sponsor, or maybe a property like an enclosed mall, where there were signs of trouble before the pandemic. We could restructure the borrower’s loan. But is that going to get us out of trouble at the end of the day? Or should we just take our lumps right now? Sometimes, your first loss is your best loss instead of kicking the can down the road.

What are you seeing in other real estate asset classes?

The increase in multifamily delinquencies is probably more a short-term phenomenon. Lease rates fell in San Francisco, for example, but now they’re starting to go back up.

I’d say the hospitality market is mostly out of the woods. Many conference centers, business hotels and other urban properties are still closed. Overall, however, hotels and leisure properties have rebounded well since the depths of the crisis, as people can drive to vacation destinations without having to get on an airplane.

For office properties, the jury is still out. COVID was the great work-from-home experiment, and it’s really been a game changer for this segment. There may be some pain for one to three more years, based on what happens with long-term office leases and market rates. But we won’t know until later this year or even 2022 what companies are going to do for sure. We do know rents have already dropped dramatically with people working remotely. This could have a big impact on large urban markets like San Francisco, New York and Chicago. In these areas, we may see significant turnover when current office leases expire.

What should CMBS investors look out for in the coming months?

I don’t see another spike in delinquencies, but there are still bumps in the road. Long-term, the enclosed mall is going to be a difficult area. In addition to the long-term impact of online shopping, taking back a large mall and repositioning it for another use is very difficult. Also, our servicing agreements and some tax laws prohibit what we can do when taking the property back.

Especially in urban cities with large commutes, CMBS investors are going to have to keep a close eye on office demand. This could have effects on hospitality and urban retail properties in these areas, so in a way it affects all these loan types. The demand-supply equilibrium will be upset, because even when companies choose to keep their office spaces, many will seek less space causing a further decline in market lease rates. That will weigh on collateral values, which could cause some real issues. Because there are so many unknowns with regard to future lease renewals, lenders may reduce loan proceeds on questionable office assets post-COVID.

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