Does Congress have cure for what's ailing CRE borrowers?

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WASHINGTON — Lawmakers are weighing a plan to help commercial real estate borrowers that are otherwise barred from accessing relief programs like the Paycheck Protection Program.

The coronavirus pandemic has forced shopping malls to a standstill, cleared out hotels and shuttered offices. All of that spells trouble for commercial real estate.

But despite calls for government relief, aiding the CRE sector is complicated by the fact that many borrowers cannot take on new debt as part of their lending terms. That makes loans issued through the PPP and the Federal Reserve's Main Street Lending Program unavailable to them.

Rep. Van Taylor, R-Texas, who sits on the House Financial Services Committee, has circulated a draft bill authorizing the Treasury Department to purchase preferred equity investments in CRE-related businesses, using funding from the Coronavirus Aid, Relief and Economic Security Act.

The draft bill "is positive in that it doesn't run afoul of the no-additional-debt covenants,” said Patrick Sargent, a partner in Alston & Bird’s finance group. “Plus, it would [provide] a return to the government ... on its money.”

Regulators and other administration officials implementing the CARES Act have struggled to figure out how best to address CRE loan defaults, with borrowers increasingly unable to service their debt without incoming revenue. In the PPP, even though aid recipients can ultimately write off the financial relief as a grant, the funds are initially disbursed as loans through third-party banks.

“This is a problem we have not addressed yet,” Rep. Andy Barr, R-Ky., said of the struggles for the CRE sector at a June 30 hearing of the House Financial Services Committee. “I think we’re going to see, without intervention, a wave of foreclosures and defaults.”

Treasury Secretary Steven Mnuchin and Federal Reserve Chair Jerome Powell told Barr that they had not yet figured out a way to set up an emergency lending facility for commercial real estate, and weren’t sure that extending debt to those borrowers would be in their best interest.

“Debt doesn’t solve every problem,” Powell said. “You’ve got people who can’t currently service debt, you’ve got these inflexible arrangements, and so there’s a serious problem here that needs to get fixed and we’re racking our brains to see how it could be something we could do by lending.”

Many commercial real estate owners financed properties with non-recourse loans that are bundled into commercial mortgage-backed securities. The terms of the loans often prevent them from taking on more debt.

“They're not looking for debt, per se, and they may be contractually prohibited from incurring it,” said Sargent.

Taylor's draft bill would enable financial institutions to acquire preferred equity instruments issued by CRE borrowers, according to a published summary. Treasury would then acquire the instruments after a given period of time and pay the financial institution additonal fees. Financial institutions could participate if they are already eligible to make PPP loans.

Taylor was one of more than 100 members of the House to sign on to a June letter to Mnuchin and Powell urging Treasury and the Fed to consider “targeted economic support” to address the illiquidity commercial real estate borrowers may be facing.

“Without a long-term relief plan in the face of an elongated crisis, CMBS borrowers could face a historic wave of foreclosures starting this fall, impacting local communities and destroying jobs for Americans across the country,” the letter said.

Second-quarter earnings reports from banks and other financial data point to continued strains on CRE owners from the coronavirus pandemic.

Only 19% of commercial property managers reported that their tenants were paying rent on time, according to a survey the National Association of Realtors conducted at the end of June.

Wells Fargo revealed July 14 that it had more than doubled its expected future losses on commercial loans, including commercial real estate loans, and JPMorgan Chase indicated that more commercial borrowers now seem likely to default on their loans than appeared to be the case three months ago. Zions Bancorp. also said this week that it expects defaults on commercial real estate loans to spike this year, noting that loans to retailers and the hotel sector are particularly at risk.

“They're battening down the hatches for what they're thinking of as a very challenging period going forward on credit,” said Walter Mix, head of the financial services practice at Berkeley Research Group and a former California banking commissioner.

Commercial real estate losses at banks “could be more pronounced” than those in the residential market because of the pandemic’s impact on the hospitality and retail industries, researchers at Deloitte Consulting warned in a recent report. Reduced demand for office space demand “could further amplify the CRE pain,” they said.

A Trepp report this month included a forecast of projected cumulative loan default rates for the hardest-hit CRE sectors in the pandemic. Based on the forecast scenario for a portfolio of 13,000 CRE loans, lodging and retail properties led the way, with cumulative projected default rates of 21.3% and 9.1%, respectively.

Before the onset of COVID-19, banks were experiencing historically low delinquency rates on commercial real estate loans. But several studies have suggested that the financial system was more exposed to risks in the CRE sector than first realized. Regional and community banks could be particularly vulnerable in a downturn.

“We're a little early in the game, but those of us who have been doing this for 25, 30 years see what's happening and are getting ready for it,” said Mix.

Delinquency rates across commercial mortgage-backed securities have tripled in the last three months, and some industry observers are increasingly worried about the lasting effect of a wave of defaults.

“If relief isn’t extended to those CMBS borrowers, the ripple effect will be felt throughout not just the commercial real estate industry but the economy as a whole, at exactly the time when those businesses could and should be helping this country return to normal,” said Wesley Shaw, the National Association of Realtors' media manager of advocacy issues.

Commercial real estate borrowers could help determine the path of the economic recovery as states begin to lift lockdown restrictions, said Shaw.

“These industries employ millions of people and they anchor communities, so they’ll play an important role in the economic recovery following the pandemic,” he said. “Of course, they need to stay in business in order to get to the point.”

Still, others argue that the future is still too uncertain to know whether commercial real estate borrowers will need extra support from the government.

Bryn Mawr Trust in Pennsylvania has set up a three-month payment deferral option for its commercial real estate borrowers with the option to extend that forbearance for another three months, and the $4.9 billion-asset bank hasn’t yet seen demand for an additional three-month period of forbearance, said Jim Egan, chief lending officer for the bank’s commercial banking business.

“We're not seeing that anxiety or need for that additional time period, so I definitely think it's still too early to tell,” he said.

Egan said the bank regulators have already taken steps helping CRE borrowers stay afloat by urging banks to offer forbearance to customers and allowing banks to make loan modifications without categorizing those modifications as troubled debt restructurings.

Mix added that he believes the bank regulators and Congress have done what they can to prop up the economy for the duration of 2020, but that he expects “a slow grind that’s going to start in 2021.”

“It's going to be a Darwinian, I think, somewhat drawn-out process of who has the staying power and who doesn't,” he said, adding that he also believes it’s too soon to know whether CRE will need additional support.

But as coronavirus cases are on the rise in many parts of the country, with some states walking back their planned reopenings, Sargent worries the outlook for commercial real estate could be dire if no action is taken.

“The urgency is the inability of this country so far to stop COVID and therefore" the need "to keep shutting down,” he said. “The impact is going to be at each level where those dollars flow. It'll be on employees, it'll be on property and business owners and then it'll be on the banks and the pension life companies, the ones that are paying retirement funds. So it's a huge deal.”

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Commercial real estate lending Federal Reserve Treasury Department Jerome Powell CARES Act House Financial Services Committee Coronavirus CRE