The CMBS Stress Test
The commercial mortgage-backed securities market is particularly vulnerable amid the COVID-19 pandemic, with borrowers and lenders looking for creative solutions to unprecedented problems.
It's easy to say nobody was entirely prepared for the global pandemic that all but shut down the U.S. economy in March. But when it comes to sectors of commercial real estate that were especially vulnerable to COVID-19, the commercial mortgage-back securities market makes a compelling case for special attention.
Representing roughly $490 billion of the $3.5 trillion in commercial real estate debt, according to the Mortgage Bankers Association, CMBS is a common financing avenue for CRE projects that, on the whole, offer non-recourse provisions, higher proceeds, and less stringent underwriting practices. Instead of a traditional bank loan, CMBS are securitized by the bond market, which provides these benefits. But such pros come with a few extra strings. One crucial characteristic of CMBS loans is that borrowers cannot, under any circumstances, add debt to an existing loan. CMBS loans are subject to oversight from the Securities and Exchange Commission and the Internal Revenue Service, meaning increased regulation and oversight.
“CMBS loans are governed by an IRS vehicle called the REMIC, or real estate mortgage investment conduit, which allows every whole dollar from a borrower to pass through to bondholders without being taxed,” says Ann Hambly, founder and CEO of 1st Service Solutions, a firm specializing in CMBS borrower advocacy through loan restructures, assumptions, and equity and debt solutions. “The minute a performing loan is modified — by adding debt, for instance — the entire pool of bonds could become taxable.”
This inherent inflexibility has been incredibly problematic amid COVID-19. Hotels that were humming along in February watched income completely disappear literally overnight. Retail outlets could not open their doors, and customers weren't leaving the house.
How We Got Here
Because CMBS loans are pooled and sold on the bond market, they don't have a typical borrower-lender relationship. Instead, they are handled by a so-called master servicer, who handles the primary responsibilities of collecting payments and communicating with borrowers. But for loans that must be modified, typically those nearing or in default, a special servicer will take over.
“In a pre-COVID world, you'd never want your otherwise performing loan to be transferred to the special servicer,” Hambly says. “There are penalties. There are fees. There's a sort of good bank/bad bank view of the world. But special servicers are the only party in a CMBS loan that can offer relief from the pain and suffering COVID 19 afflicted on all commercial property owners.”
To put our current situation in perspective, the special service rate for all CMBS loans held relatively steady in 2019 and early 2020, dipping to a low of 2.83 percent in March, just as the pandemic started shutting down large swathes of the American economy. In the following two months, that rate more than doubled, reaching 6.07 percent in May.
“A large amount of CMBS borrowers are going to need relief,” says Hambly. “It's hard to comprehend a scenario where we'd be able to classify someone as a bad borrower because of COVID-19, but it doesn't feel good for borrowers. There's a negative connotation to it. There are certain perceptions of going to a special servicer.” Hospitality is the industry that was the hardest hit by the initial first wave of the pandemic. It's special-servicing rate skyrocketed from 2.27 percent in March to 20.5 percent in June. Retail wasn't far behind, nearly tripling from 5.31 percent in March to 14.3 percent in June.
“I tell a lot of people, it's similar to how humans are susceptible to the coronavirus. If you are elderly or have asthma or other pre-existing conditions, you will likely not fare as well as someone who is in their 20s and healthy,” Hambly says. “This is true with properties as well. If you were hanging on by a thread and weren't doing great before COVID-19, chances are, you aren't faring so well now.”
Amid the cataclysmic economic freefall in March, Congress passed the CARES Act, a $2 trillion package of bailout initiatives aimed at minimizing the economic impact of the pandemic. But the programs designed to help businesses were, by and large, unable to help CMBS borrowers. The $500 billion in small business loans could not help CMBS borrowers because it added to their debt.
“The first question is, well, why don't you change that?” says Steve Banegas, chief operating officer at 1st Service Solutions. “If only it were that simple. Such a change would require a change to the law. It would fundamentally change how the CMBS industry operates.
The CARES Act's Paycheck Protection Program was one initiative that could help CMBS borrowers, because the aid money is considered a grant rather than a loan. The relief does not have to be paid back — something loan servicers needed clear confirmation of. Weeks later, on April 13, the IRS issued updated REMIC guidelines intended to facilitate loan modifications. What these rules truly mean in practice, however, is a matter of discussion.
“These rules are high-level adjustments,” Hambly says. “It didn't have many specifics. So, at that time, servicers huddled with REMIC councils and tried to figure out what could and could not be done. Some servicers started to allow borrowers to use reserves to make up to three months of payments. But other servicers concluded they weren't comfortable making any adjustments. They didn't want to risk breaking the REMIC, so that April update didn't work at all for them.”
Into the summer, many servicers continue to take a hard line on potential modifications to loans. Many borrowers are left scrambling for short-term relief, such as a 90-day forbearance, to keep from having to go to special servicing.
Where to Go from Here
The future, as the saying goes, has yet to be written, which isn't much comfort to CMBS borrowers who are doing everything in their power to stay afloat while waiting for an economic recovery and/or new avenues for relief to open up.
“At the start of [the COVID-19 pandemic], it was more panic and anxiety than anything for borrowers,” Banegas says. “But we are now seeing more frustration because people are running out of patience. If you don't have any workable options, what can you do?”
On the servicing side of the equation, the sentiment is much calmer. The structure of CMBS puts the law on their side, meaning, when the going gets tough, they have leverage. Outside of a rush to special servicing — which, again, topped 8 percent in June — something must happen to avoid a meltdown of the market. Hotels, retail locations, multifamily properties, and even office borrowers are hanging on through the tools available to them, including forbearance and reserve spending. But these solutions offer short-term relief to a problem that doesn't appear to be going away anytime soon.
“There's the million-dollar question: What happens at the end of that window?” Banegas asks. “Well, they need income coming in. If you're a hotel, you are hoping the economy is opening up and people are starting to book reservations. Otherwise, you're in the same position you were in March, where you are looking to go to special servicing.
“A lot of people with CMBS are looking at a rough road ahead. It could be a difficult time if things aren't up and running after folks spend three months of reserves.”
The initial round of government aid didn't help in a significant way, all while future bailouts or rule adjustments appear far from imminent. Additionally, fundamental changes to the economy could have serious consequences for businesses across the country.
“All of a sudden, losing retail tenants, for example, a property that was going great a year ago may not work after COVID-19,” Hambly says. “To that end, we're entering a multiyear correction. The [Great Recession] was brought on for different reasons, but we're going to have a period after COVID-19 relief that feels a little like that.”
Yes, CMBS is based on a system that's much more complex than a traditional loan, where a borrower can call up the local banker to discuss a potential solution that would benefit both parties in a time like COVID-19. For the CMBS industry to survive this pandemic, it may come down to cooperation and a willingness for servicers, regulators, and borrowers to come up with a solution to overcome a once-in-a-century crisis.
“If CMBS special servicers work with the market and borrowers and grant reasonable relief for reasonable fees, I think we'll have a CMBS market to talk about after COVID-19,” Hambly says. “If they don't and they view this as an opportunity to play hard ball and make money on fees without giving any real relief to borrowers, or worse, taking properties away from owners through foreclosure, I think we're, in essence, killing the CMBS market.”
For more on this topic, check out CCIM Institute's “Commercial Mortgage-Backed Securities Financing" course.