Commercial real estate: it's always darkest before dawn

A spring of dramatic change and uncertainty

Commercial real estate suffered during the pandemic: Hotels were shuttered, malls and retail tenants had to adapt quickly to online shopping as brick-and-mortar stores were closed, office buildings emptied as working from home went mainstream, urban apartment complexes lost occupancy as people fled to suburbia, and demand for industrial properties soared as online shopping overwhelmed shipping networks. Uncertainty soared in the early spring of 2020 as echoes of the Great Recession resonated in the media. Property owners wondered how with minimal income they would pay debts. Price deterioration mirroring or exceeding prior recessions seemed likely, as the economy collapsed in a manner unlike anything since the Great Depression of 1929.

But this time around, the feared real estate implosion wasn’t based on excessive building or leverage. Confidence remained, and financial institutions were willing to work with borrowers to avoid defaults and foreclosures. Consensus was that the pandemic would eventually pass; still, investors wondered how much carnage would be left behind. Thankfully, most of the worst fears don’t appear to have become reality. 

Prices fell—or did they?

Real estate prices did fall, but less than had seemed likely. Experiences have varied widely by subsector: Industrial and apartment prices remained relatively steady and have begun rising to new highs again. Hotels and retail properties were the hardest hit, with prices falling anywhere from 10% to 50%, depending on property and location. These two property types may forever be changed as travel habits shift and shoppers get more comfortable with e-commerce. The decline in retail has been occurring for years and accelerated during the pandemic.

The office sector is a tough call from here. The success of working from home was probably one of the pandemic’s biggest surprises, and noncommuting is unlikely to stop even after the pandemic is well under control. The percentage of people working from home remains to be seen. It’s likely that demand for office space may shrink in the future as companies seek to cut costly real estate expenses. 

Distressed sales have remained low in the pandemic, unlike in the global financial crisis

Source: Real Capital Analytics (RCA) Commercial Property Price Index (CPPI), Morgan Stanley, 3/31/21. LHS refers to left-hand side, RHS refers to right-hand side.

The real pain was in debt, but the picture has improved

While property prices held mostly steady, debt exhibited more price volatility and typical recession patterns. Loan defaults eventually soared, primarily in hotel and retail properties, as most were forced to close or sharply curtail business. With virtually no income from hotel travelers and with retail tenants not paying rent, it was only a matter of time before loans defaulted. The commercial mortgage-backed securities (CMBS) market endured a sharp rise in delinquencies consistent with the Great Recession, and even conservative life insurance underwritten loans experienced similar deterioration. 

Delinquencies (%) spiked early in the pandemic but have been steadily falling

Source: Mortgage Bankers Association, Trepp, Morgan Stanley, 12/31/20. CMBS refers to commercial mortgage-backed securities. REO refers to real estate owned  by lender after unsuccessful foreclosure auction.

While the headline default numbers seem large, the true permanent defaults may be lower as the pandemic recedes and the economy returns to life as usual. We may be able to see this in the amount of distressed loans available for sale. Given the magnitude of the hit to the economy, many would have expected the fallout in asset prices to be larger and longer lasting. This didn’t happen. Banks are better capitalized than in the last global financial crisis, and the government poured seemingly endless stimulus into the economy, sponsoring a wide range of rescue lending. The amount of distressed loans following a recession is usually high, but we’re sitting on the lowest amount of distressed sales in a decade. This wasn’t a typical recession, and banks weren’t left with poorly underwritten loans to liquidate like in the Great Recession. Real estate underwriting is far more conservative today, and billions of dollars of capital remain on the sidelines, prepared to be invested in commercial real estate. 

Substantial assets are available for securitized debt investment

Source: Preqin, Morgan Stanley, 7/24/20.

Where do we go from here?

Spring is here and so are the green shoots in commercial real estate. Securitized debt investors typically take a different approach to the sector than equity investors, with less emphasis on forecasting property price direction and more on debt coverage and principal protection. While larger opportunities presented themselves last year, investors are once again left navigating through a low-yield environment and searching for relative value opportunities. Areas of interest include CMBS, single-asset deals, multifamily transactions, and a variety of structured bonds with unique characteristics. Investing in structured commercial real estate provides a diversified approach to gaining exposure to many properties in multiple locations and may provide the opportunity to earn attractive risk-adjusted returns.