Perhaps no credit market is as much a bellwether for the economic crisis caused by the COVID-19 pandemic than commercial mortgage-backed securities (CMBS). While the impact of relief programs on consumer-based markets remains to be seen, CMBS offers a broad view into the health of consumers, vulnerable industries, the success of stimulus programs on small and medium-sized businesses and the overall economy. Deals in the pipeline may be in jeopardy as parties re-evaluate their positions and consider the outlook for commercial tenants in vulnerable areas, such as hospitality and retail. Meanwhile, performance of existing deals may be impacted by commercial tenant insolvencies and suspensions of bankruptcy proceedings.
Cracks in the Foundation
2019 was the "strongest year for U.S. CMBS issuance since the last financial crisis," according to an S&P report, and this growth was expected to carry over into 2020. Needless to say, the picture is now very different - CMBS issuance is now predicted to "decline significantly" this year in light of the COVID-19 pandemic, by as much as 30-40%. This may be offset, to some extent, by the re-introduction by the Federal Reserve of the Term Asset-Backed Securities Loan Facility (TALF). This $100 billion facility was recently expanded to allow investors to purchase triple-A rated CMBS bonds issued before March 23, 2020, and may help to sustain the CMBS market as lending dries up.
In March 2020, the delinquency rate for U.S. CMBS loans tracked by Fitch was 1.31%, representing a year-over-year decrease. However, the rating agency is now expecting delinquency rates to rise to between 8.25% and 8.75% by the end of Q3 2020. As Fitch points out, this is not far off the peak of 9.01% in July 2011 following the financial crisis. Hotels and retail are likely to see the worst concentrations, with delinquencies projected to rise to 30% and 20%, up from 1.44% and 3.51% respectively, although retail properties with tenants in essential industries, such as supermarket, pharmacies and banks, will not be as greatly impacted.
The retail industry had been struggling even before the pandemic, and it is now one of the most at-risk sectors. At the end of March, S&P lowered ratings, on 60 classes from 24 U.S. CMBS transactions citing exposure to underperforming retail loans, and not the coronavirus outbreak. S&P cautioned that COVID-19 will likely accelerate performance declines for properties with retail exposure.
As with other ABS sectors, it may still be too early to see any worsening performance that is specifically related to the coronavirus. S&P's analysis suggests, however, that there are underlying cracks in the retail CMBS sector that make it particularly vulnerable to the effects of a recession.
Workout Requests Rising
Behind the scenes of the massive unemployment numbers are ailing companies in a diverse range of industries following the closure of non-essential businesses. Some commercial tenants have been asking landlords for relief in the form of rent abatements, lease amendments and revenue-sharing agreements, while others - including Cheesecake Factory, Mattress Firm and Equinox - have been experiencing similar difficulties and have either temporarily reduced or halted their rental payments.
Fitch Ratings initially reported that 2,600 commercial real estate borrowers sought potential debt relief during the first two weeks of the outbreak. That number has since risen to nearly 5,500. Of these relief requests (the most common of which were forbearance, reallocation of reserves and waivers of default), 75% are coming from retail, hotel and multifamily properties, illustrating how these sectors have been the worst-hit.
If the pandemic continues to affect tenant businesses, borrower requests will shift from forbearances to modifications involving term extensions, interest-rate reductions and principal forgiveness. According to Fitch, so far less than 2% of CMBS debt has been referred to special servicers for restructuring or modification, but more will likely be coming. Modifications impact a wider group of parties who might be less willing to agree to changes.
Bankruptcy Becoming Less Predictable
With difficulties collecting rent, commercial landlords may in turn fall into arrears on their mortgages. Landlords' difficulties may well be compounded by bankruptcy courts suspending tenant bankruptcies indefinitely and granting unusual relief to tenant-debtors due to the coronavirus.
Normally, under the Bankruptcy Code, commercial landlords are afforded special rules and protections not applicable to other creditors. While a tenant is a debtor in bankruptcy, all efforts to collect outstanding rent payments must be halted, but the commercial tenant debtor does not have an indefinite time to get its house in order. The debtor generally has up to 210 days from the filing of its bankruptcy to assume (i.e., accept), reject or assume and assign unexpired commercial leases.
The debtor's decision is of great consequence to the landlord: If a lease is rejected, the landlord may assert a claim for "rejection damages," but they are capped at the greater of one year's rent or 15% of the remaining lease term (not to exceed three years' rent) plus unpaid pre-petition rent. If the lease is assumed (or assumed and assigned), the debtor must cure all defaults under the lease (including payment of pre-petition rent), demonstrate its (or its assignee's) ability to perform under the lease and satisfy certain other requirements, including, in the case of a shopping center, that the assumption or assignment does not disrupt the center's tenant mix.
Collection of post-petition rent is usually predictable: As a unique protective right for landlords generally unavailable to other creditors under commercial contracts, the Bankruptcy Code requires a commercial tenant to perform all post-bankruptcy obligations, which includes payment of post-petition rent, until it assumes or rejects the lease.
However, in the time of COVID-19, commercial landlords cannot be certain that debtors will timely pay even post-petition rent obligations. Citing the coronavirus, courts have recently entered orders suspending bankruptcy cases, thereby "mothballing" liquidation efforts and deferring payment of post-petition rent until after the suspension is lifted. Suspension is an extraordinary, rarely-seen remedy, and the deferment of rent directly contravenes the Bankruptcy Code's requirement that rent be paid timely. Therefore, landlords should brace for the impact of commercial tenants' bankruptcies now more than ever.
Given CMBS is effected by so many aspects of the economy, it is extraordinarily sensitive to the success or failure of government relief programs, social distancing programs and scientific efforts to control the virus.
There are many areas where conflicts will need to be resolved. For example, if there are deals in progress which are no longer attractive or even viable, parties may look to their contracts to see if they can avoid obligations under force majeure or material adverse effect/material adverse change clauses. If suspensions of tenant obligations continue in bankruptcy, it will force more out-of-court workouts. If parties see an opportunity to recover some of what they've lost through repurchase requests, we could see a spike in disputes. While a substantial body of law has developed through years of litigation involving repurchase protocols in pre-financial crisis RMBS, significant differences in repurchase enforcement procedures for CMBS - including asset review and dispute resolution processes - make it important for interested parties to consult with experienced counsel to determine which lessons learned in RMBS litigation can be applied to CMBS disputes.
That's a lot of "ifs" that point to an unpredictable future. Some companies, like Morgan Stanley, are learning now they may not need office space like they thought they did. Consumer behavior may become irrevocably changed, leaning on online shopping over brick-and-mortar going forward. While the immediate environment is one of trying to keep tenants afloat and maintain CMBS liquidity, the efforts are against the backdrop of existential questions regarding the use and need for commercial space on the other side of this crisis.
Seiji Newman, Massimo Giugliano, Joel Melendez, Andrew Spillane and Nicole Serratore, members of the Insolvency, Creditors' Rights & Financial Products Practice Group of Davis & Gilbert, contributed to this post.
Emily Hatchett, a paralegal in the Insolvency, Creditors' Rights & Financial Products Practice Group of Davis & Gilbert, assisted with this post.
Originally published Apr 28, 2020
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