Seeking Clues to the Performance of Real Estate Loans in Bank Portfolios

More than half of the $4.7 trillion in commercial real estate (CRE) loans is held in the portfolios of large and small commercial banks around the country.^[1] The pandemic has resulted in a significant loss of rental revenue for many property owners, particularly in retail and hospitality, as those are the sectors most impacted by lockdowns and changing consumer and traveler behavior. A year ago, most properties had plenty of cash to fund mortgage payments. Today, banks are facing the possibility that owners will not have the cash to make payments and defaults will follow. Given the stress in the system, are bank CRE loan portfolios continuing to perform? The answer: We don’t know.

When much of the country went into virus prevention lockdown, bank regulators and Congress acted quickly to encourage banks to work with borrowers impacted by the pandemic. In March (and again in August), regulatory guidance was given to lenders to prudently work with borrowers including modifying loan terms and granting forbearance. This accommodative attitude was codified in the CARES Act. Once a loan is modified, and then performs in accordance with the new terms (which may be a deferral of payments for several months), the banks are allowed to continue to classify those loans as performing, with no required downgrade to the risk rating and no troubled debt accounting treatment.^[2] The upshot is that banks are not required to report on loans that have been successfully modified, and so we have few clues as to how well their commercial mortgages have actually performed since March. The regulators of life insurance company lenders took a similar stance in accommodations to statutory accounting principles.

Reported CRE loan delinquency remains very low. According to the Mortgage Bankers Association, commercial and multifamily loans on bank balance sheets had a 90+ day delinquency rate of 0.64% on June 30, 2020, up from 0.42% at the end of 2019. Not bad considering the suddenness and severity of the downturn. But also not surprising given the regulatory guidance. What is really happening at the banks? Perhaps the recent experience of non-bank lenders will provide some clues.

There is significant data and transparency relating to loans funded through commercial mortgage-backed securities (CMBS), which have not had the benefit of the regulatory and legislative accommodations. Property owners that borrow funds through CMBS offerings have no lender per se, and request loan forbearance and modification from an issuer’s special servicer, which must follow the rules of a pooling and servicing agreement designed to protect the bondholders. Servicers must report loan performance monthly. While the credit characteristics of CMBS and bank loans may be different, understanding what is happening in the CMBS market might provide directional insight into what may occurring in bank portfolios.

First Clue – Forbearance

The first indication of distress is a borrower’s request for forbearance, a temporary deferral of all or a portion of monthly loan payments. The CMBS bond analytics firm Trepp has painstakingly read through the servicing notes on thousands of loans and estimated that 400 loans with an aggregate balance of $16.6 billion had received forbearance relief by July, doubling to 800 loans with an aggregate balance of $31.2 billion by September (only 60 days later) -- an amount representing about 5% of all outstanding CMBS loans. Of these loans, 64% were collateralized by hotels, 28% by retail, and 5% by mixed-use properties that typically include ground floor retail. Trepp only counted what were described as completed forbearance agreements and did not include “hundreds, if not thousands, of loans for which ‘forbearance request is under review.’” This rising number of forbearance agreements and outstanding forbearance requests confirms that the pandemic is eroding the liquidity of real estate owners.

Life insurance companies are also significant lenders to commercial property owners, and have received similar regulatory guidance on borrower accommodations as the banks. While it is difficult to find data on portfolio performance, a recent study by Fitch found that 9% of the CRE loans in life company portfolios have been granted some form of relief, 52% of which were collateralized by retail properties and 26% by hotel properties. Fitch noted that retail makes up 19% of life company CRE portfolios, while hotels are just 4%.

Second Clue – Delinquencies and Special Servicing

Delinquent loan payments are a more urgent indication of borrower illiquidity. According to the Mortgage Bankers report, life insurance company 60+ day delinquencies were just 0.15% in June. This low metric may reflect the traditionally higher quality of insurance company lending and also the fact that 75% percent of their portfolios, on average, are secured by property types that have not been as negatively impacted as hotels and retail. The number may also be low because of the significant number of forbearance agreements referenced above.

Accordingly to a CRE Finance Council (CREFC) report based on Trepp data, CMBS delinquencies peaked in June at 10.3% and have moderated each month since, possibly due to the increasing number of forbearance agreements or the reallocation of reserves to fund debt service. At the end of October, average delinquency for all CMBS loans had fallen to 8.3%. The October figure translates to over 1,700 loans with a total balance of about $46 billion. As a point of reference, delinquencies at the end of 2019 were just 2.2%.  Of the delinquent loans, about $10 billion are in the foreclosure process or already real estate owned (REO), as will be discussed below. It should also be noted that almost $17 billion in payments on an additional 700 CMBS loans, were late; but either within their grace period or less than 30 days past due and therefore not classified as delinquent.

As expected, CMBS delinquency rates vary by property type. Hotels, which always suffer first in a downturn and were particularly hard hit by the enormous drop in business, tourist, and convention room demand, had a delinquency rate of 19.3% in October, down from 24.3% in June. Retail, the other great pandemic real estate casualty, had a delinquency rate of 14.1% in October, down from 18.0% in June. Rates for the other property types are shown in the table below.

Another indicator of CMBS loan performance is special servicing activity. Servicers maintain a loan watchlist for each issuance based on formulaic statistics intended to predict potential non-performance. According to the CREFC October report, 26.5% of all CMBS loans were on these watchlists. Transfers of loans to special servicing occurs either when a borrower requests a transfer due to an anticipated inability to make debt service payments, or involuntarily once the loan is delinquent. Per the CREFC report, by the end of October, the percentage of CMBS loans in special servicing grew to 10.3% from 2.7% at the end of 2019. Again, loans collateralized by hotels and retail properties accounted for most of that population.

CMBS Loan Performance as of October 2020

   Source: CREFC and Trepp

Third Clue – Foreclosures

Banks typically use foreclosure as a last resort when loans fail to perform. They are not in the business of managing properties and, particularly in this environment, don’t want to own hotels and malls that will require a lot of capital and time to recover. Moreover, holding property rather than loans requires significantly more regulatory capital.

The longer the economic impact of the pandemic lingers, the more forbearance agreements will expire and, if property cash flow still cannot service the debt, foreclosures will increase unless borrowers receive fresh infusions of capital. If a bank enters into a forbearance agreement with a borrower and the borrower defaults, that loan would then be reclassified as nonaccrual (non-performing) and banks would have to report that information.

In CMBS, foreclosures are already occurring. As noted above, about $10 billion of loans is already either in the foreclosure process or REO. According to Trepp, there are also almost $4 billion of loans not in the REO designation that are in discussions for a deed-in-lieu of foreclosure, that is, a voluntary non-judicial property conveyance. As with delinquencies, most of these loans are collateralized by retail properties and hotels. While not all of these loans will ultimately convert to REO, the data demonstrates that when borrowers feel there is little hope of property recovery or cash has run out, they will be forced to turn the keys over to the lender and walk away from their equity investment.

What’s Next: The Big Reveal in 2021

What do these clues tell us about bank CRE loan performance? Based on both life insurance company and CMBS experience, about 5%-10% of loans are in some form of forbearance. Including the data on CMBS delinquencies, special serving, and foreclosure trends suggests that around 15% of portfolios may be at risk of default. The problem loans are heavily concentrated in loans collateralized by retail and hospitality properties. If a bank has a similar concentration of retail and hospitality properties in its portfolio, it is reasonable to predict that once the forbearance period has ended the bank will experience similar levels of troubled debt.

Banks, unlike CMBS, also hold construction and transitional loans which have greater credit risk than stabilized commercial mortgages. Beyond exposure to loss of tenant rent, borrowers have completion and lease up risk. While such loans may be well underwritten and have had low leverage at origination, declining tenant demand for space in the near term may stall what would otherwise have been successful projects.

Given the lengthening pandemic, persistently high unemployment, and the continuing erosion of real estate borrower liquidity, it is likely commercial mortgage loans will continue to show distress for some time to come. Borrowers and their lenders will have to work together on loan modification strategies that work for both parties. Banks are unlikely to be immune from the stress. To date, regulatory guidance has veiled bank CRE loan portfolio performance. Unless the accommodative environment is extended, by the first quarter of 2021 banks will begin to disclose statistics on loan modification and forbearance agreements. Only then will we have a clearer picture of whether banks will suffer the same magnitude of losses in the COVID-19 recession as they did in the Great Financial Crisis a decade ago.

[1] Federal Reserve, June 30, 2020

[2] For additional information on the regulatory guidance and CARES Act rules, please see The Accommodative Climate for Modifying Bank Loans, September 17, 2020