- The lockdowns related to the COVID-19 pandemic have hurt the cash flows and values of many U.S. commercial real estate properties.
- As a result, we expect the eight U.S. nonbank CRE lenders we rate to face elevated asset-quality challenges.
- Hotel and retail portfolios should be affected most, while many office properties face uncertainty and some multi-family properties might not be immune.
The COVID-19 pandemic's massive impact on travel, shopping, office space usage, and other elements of the economy has made commercial real estate (CRE) one of the asset classes most likely to feel the effects--both in the short and long term. The cash flows and values of many CRE properties--most notably those focusing on hotels, entertainment venues, and certain retail properties--have already declined substantially or will decline. This could lead to struggles meeting their mortgage obligations. As a result, we expect the eight U.S. nonbank CRE lenders we rate to face elevated asset-quality challenges. (For more on bank CRE portfolios, see "U.S. Banks Face Long-Term Risks To Their Commercial Real Estate Asset Quality," also published today.) Hotel and retail portfolios should be affected most, but office and multifamily portfolios will feel the impact as well.
These lenders also often focus on transitional properties and to--a lesser extent--construction loans, both of which typically hold more risk than CRE loans on stabilized properties. Transitional properties generally are not fully leased and are undergoing improvements or being repositioned. Transitional loans typically are three years in duration and often have two one-year extension options. These loans are underwritten with the expectation that the borrower will execute its business plan and the loan will eventually be refinanced at terms based on fully stabilized cash flows.
The Mix Of Loans Varies Property Types
The mix of loans by property type varies among the nonbank lenders that we rate (see Chart 1). We believe loans collateralized by hotel and retail properties are at the most immediate risk, but we also see longer-term uncertainty for office properties.
Since the pandemic-related lockdown in March, hotel vacancies have increased, and revenue per available room has plummeted, which has put significant pressure on hotel properties. Although the pandemic hasn't spared hotels that customers can reach by car, we believe they've fared better than hotels customers must fly to given that COVID-19 has also hit air travel hard. Hotel exposure among the CRE lenders we rate ranged from 4% to 24% as of June 30, 2020, with Apollo Commercial Real Estate, iStar and Starwood Property Trust having the greatest exposures in their CRE loan portfolios.
Although the pandemic has resulted in many retail bankruptcies, retail properties account for less than 10% of loans for most of the nonbank lenders that we rate. Many of these lenders were already cautious about retail, given the challenging outlook for retail long before the pandemic. Also, many of these lenders have focused on necessity retail--such as drug stores--which has suffered less than more discretionary retail.
The demand for office space is uncertain, in our view, reflecting the potential for more work to be conducted offsite even after the pandemic. We believe this is particularly the case in cities such as New York and San Francisco, where there are high costs, long commutes that rely on mass transit, and crowded office towers.
Regardless of the pandemic, everyone still needs a place to live, so we believe that risks to multi-family properties are less than hotels, retail, and office. Nevertheless multi-family properties are not immune, and we expect that heightened unemployment will have at least some impact on rent collections, while there could be decreased demand for condos in urban centers.
CRE Lenders Have Increased Their Allowances For Loan Losses
Many of the CRE lenders that we rate were formed in the aftermath of the 2008-2009 global financial crisis and have only operated in a benign credit environment prior to the COVID-19 pandemic. As a result, many of these lenders have had little, if any, credit losses, and their loan loss reserves have tended to be minimal. For those that adopted the CECL (current expected credit loss) method this year, which requires life-of-loan reserves, loan loss reserves generally are at least 1.0% of loans but in some cases over 3.0% (see Chart 2). Privately held lenders are not required to adopt CECL yet, so they generally only establish specific reserves for impaired loans. Through the first half of 2020, net-charge-offs generally have been negligible, but we believe that will be difficult to sustain the longer the pandemic disrupts normal economic activity. We believe most of these lenders have adequate equity cushions to absorb losses, with debt to adjusted total equity under 4x in most cases and under 2x in some cases.
Repurchase Facilities Pose Margin Call Risk For Many
Many of the finance companies we rate rely heavily on repurchase facilities for funding--in some cases for more than half of their borrowings (see Chart 3). The risk of margin calls related to repurchase facilities is elevated, in our view. However, terms and conditions vary across facilities, and some are at greater risk than others. While some facilities allow for collateral to be marked based on market interest rates and credit spreads, many others only allow it to be marked based on credit valuation adjustment events. Also, advance rates under some facilities are subject to look-through advance rates, while others are not. Portolios of CRE securities--particularly CRE CLO tranches--financed with repurchase facilities subject to market based marks came under the most pressure for margin calls during the spring, when market volatility spiked. Although financing conditions have improved from earlier this year, and many of these companies have added liquidity and negotiated some margin call relief, we still view the sector's funding and liquidity risks to be elevated.
Negative Outlooks For CRE Lenders
Earlier this year, we downgraded six of the eight CRE lenders we rate, with the downgrades mainly reflecting weaker assessments of funding profiles amid difficult financing conditions. Although many of these companies have bolstered liquidity and negotiated some margin call relief, we currently have negative outlooks on all eight CRE lenders that we rate (see table). The negative outlooks mainly reflect the potential for asset quality to weaken, resulting in delinquencies and credit losses, as well as the potential for more margin calls over the next 12 months.
|CRE Finance Companies' Rating Factor Assessments As of Nov. 2, 2020|
|Company||Anchor||Business position||Capital, leverage, and earnings||Risk position||Funding/liquidity||Comparable ratings adjustment||Issuer Credit Rating||Outlook|
|Apollo Commercial Real Estate Finance, Inc||bb+||Moderate||Strong||Moderate||Moderate/Adequate||-1||B+||Negative|
|Blackstone Mortgage Trust, Inc.||bb+||Moderate||Adequate||Moderate||Moderate/Adequate||0||B+||Negative|
|Claros Mortgage Trust, Inc||bb+||Moderate||Strong||Moderate||Moderate/Adequate||-1||B+||Negative|
|KKR Real Estate Finance Trust Inc.||bb+||Moderate||Adequate||Moderate||Moderate/Adequate||1||BB-||Negative|
|Ladder Capital Finance Holdings LLLP||bb+||Moderate||Adequate||Adequate||Moderate/Adequate||0||BB-||Negative|
|LoanCore Capital Markets LLC||bb+||Weak||Moderate||Moderate||Moderate/Adequate||1||B||Negative|
|Starwood Property Trust Inc.||bb+||Moderate||Strong||Moderate||Moderate/Adequate||0||BB-||Negative|
This report does not constitute a rating action.
|Primary Credit Analyst:||Matthew T Carroll, CFA, New York + 1 (212) 438 3112;|
|Secondary Contacts:||Brendan Browne, CFA, New York + 1 (212) 438 7399;|
|Adam Grossbard, CFA, New York + 1 (212) 438 8283;|
|Diogenes Mejia, New York + 1 (212) 438 0145;|
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